Municipal bonds

Definition

Municipal bonds are debt securities issued by state and local governments to finance public projects such as schools, highways, and infrastructure improvements. Investors buy these bonds to lend money to the issuer in exchange for periodic interest payments and the return of the bond's face value at maturity. They are an essential part of the bond market, offering tax advantages that make them attractive to individual and institutional investors.

5 Must Know Facts For Your Next Test

1. Municipal bonds are often favored by investors in higher tax brackets because the interest earned is generally exempt from federal income tax and sometimes state and local taxes as well.
2. There are two main types of municipal bonds: general obligation bonds, which are backed by the issuer's credit and taxing power, and revenue bonds, which are repaid from the income generated by specific projects.
3. The issuance of municipal bonds can help fund critical infrastructure projects that improve public services and promote economic growth within communities.
4. Municipal bonds are typically considered lower-risk investments compared to corporate bonds, as they are less likely to default given their backing by government entities.
5. The bond market's overall performance can influence municipal bond yields, with changes in interest rates impacting their attractiveness relative to other investment options.

Review Questions

• What factors contribute to the appeal of municipal bonds for investors, particularly those in higher tax brackets?
  • Municipal bonds appeal to investors, especially those in higher tax brackets, primarily due to their tax-exempt status on interest income. This means that individuals do not have to pay federal income taxes on the earnings from these bonds, which can result in a higher effective yield compared to taxable investments. Additionally, municipalities often have stable revenues and lower default rates than corporations, making these bonds a safer investment choice.
• Compare and contrast general obligation bonds with revenue bonds in terms of their structure and risk profile.
  • General obligation bonds are secured by the full faith and credit of the issuing municipality, meaning they rely on the government's ability to levy taxes to repay bondholders. In contrast, revenue bonds are backed by specific revenue sources generated from projects such as tolls or service fees. This makes revenue bonds generally riskier since their repayment depends on the success of a specific project rather than broader government finances. Investors must weigh these differences when considering their investment strategy.
• Evaluate the impact of changes in interest rates on municipal bond investments and how this reflects broader trends in the bond market.
  • Changes in interest rates have a significant impact on municipal bond investments. When interest rates rise, newly issued bonds offer higher yields, making existing municipal bonds with lower rates less attractive. As a result, the prices of existing municipal bonds tend to fall in response to rising rates. Conversely, when interest rates decrease, existing municipal bonds become more valuable as their fixed interest payments remain attractive. This dynamic reflects broader trends in the bond market, where shifts in monetary policy and economic conditions can greatly influence investor behavior and bond valuations.

Related terms

Tax-exempt bonds: Bonds whose interest income is not subject to federal income tax, often including many municipal bonds.

General Obligation Bonds: Municipal bonds backed by the full faith and credit of the issuing government, meaning they are secured by taxing power.

Revenue Bonds: Municipal bonds that are secured by specific revenue sources, like tolls from a highway or fees from a public utility.