Municipal Bonds

Definition

Municipal bonds are debt securities issued by states, municipalities, or other governmental entities to finance public projects, such as infrastructure, schools, and hospitals. They are attractive to investors because the interest income earned is often exempt from federal income tax and, in some cases, state and local taxes, making them a popular choice for those seeking tax-efficient investment options.

5 Must Know Facts For Your Next Test

1. Municipal bonds are generally considered to be lower-risk investments compared to corporate bonds, due to the backing by government entities.
2. The interest rates on municipal bonds can vary widely depending on the credit rating of the issuer and prevailing market conditions.
3. Investors in municipal bonds should consider factors like the bond's maturity date and whether it is callable, which affects the bond's value and interest rate risk.
4. Some municipal bonds may be subject to alternative minimum tax (AMT), which means that high-income earners should be aware of their potential tax implications.
5. The market for municipal bonds can be less liquid than other types of bonds, meaning it might be harder to buy or sell them quickly without affecting their price.

Review Questions

• How do municipal bonds differ from corporate bonds in terms of risk and tax advantages?
  • Municipal bonds are typically considered lower risk compared to corporate bonds because they are issued by government entities that have taxing power. Additionally, the interest income from municipal bonds is often exempt from federal income tax and sometimes state and local taxes, making them more attractive to investors in higher tax brackets. In contrast, corporate bond interest is fully taxable, which can reduce the effective yield for investors.
• Evaluate the impact of interest rate changes on the valuation of municipal bonds and their market demand.
  • When interest rates rise, the prices of existing municipal bonds typically fall, as newer issues come with higher yields. This inverse relationship affects investor demand; if rates are expected to rise, investors may hesitate to purchase existing bonds due to their lower yields. Conversely, when interest rates decline, existing municipal bonds become more valuable since they offer higher yields compared to new issues. Therefore, market conditions significantly influence municipal bond valuations.
• Critically assess how the characteristics of general obligation and revenue bonds affect investor decisions regarding municipal investments.
  • General obligation bonds are backed by the full faith and credit of the issuing government entity and are supported by tax revenues, which can provide a sense of security for investors. In contrast, revenue bonds are dependent on specific project revenues, making them potentially riskier if those projects do not generate expected income. Investors will weigh these characteristics based on their risk tolerance and investment goals; those seeking stability may prefer general obligation bonds, while those willing to accept more risk for potentially higher yields might opt for revenue bonds.

Related terms

Tax-Exempt Bonds: Bonds whose interest payments are not subject to federal income tax and often state and local taxes, making them appealing for investors in higher tax brackets.

General Obligation Bonds: Municipal bonds backed by the full faith and credit of the issuing government entity, supported by tax revenues rather than specific project revenues.

Revenue Bonds: Municipal bonds that are secured by the revenues generated from specific projects or sources, such as tolls from a toll road or fees from a public utility.