Municipal bonds

Definition

Municipal bonds are debt securities issued by states, municipalities, or counties to finance public projects such as schools, highways, and infrastructure. These bonds are attractive to investors due to their tax-exempt status, often offering lower interest rates compared to corporate bonds while providing a steady income stream.

5 Must Know Facts For Your Next Test

1. Municipal bonds are typically considered low-risk investments since they are issued by government entities and have lower default rates compared to corporate bonds.
2. Investors in municipal bonds may receive interest payments that are exempt from federal taxes and potentially state and local taxes, depending on their residency and the bond's origin.
3. The market for municipal bonds is heavily influenced by interest rates; as rates rise, existing bond prices generally fall, impacting their valuation.
4. Municipal bonds can be used to fund a variety of public projects, including infrastructure development, public education facilities, and healthcare institutions.
5. Credit ratings for municipal bonds are crucial in determining their interest rates; higher-rated bonds will have lower yields compared to those with lower ratings due to perceived risk.

Review Questions

• How do municipal bonds compare to corporate bonds in terms of risk and tax benefits?
  • Municipal bonds are generally considered lower risk compared to corporate bonds because they are issued by government entities with a strong track record of repaying debt. Additionally, the interest earned on municipal bonds is often tax-exempt at the federal level and sometimes at the state and local levels, making them particularly attractive to investors in higher tax brackets. In contrast, corporate bonds typically carry higher interest rates to compensate for the greater risk associated with private companies.
• Discuss the difference between general obligation bonds and revenue bonds within the context of municipal financing.
  • General obligation bonds are secured by the full faith and credit of the issuing municipality and are backed by its taxing authority, meaning that taxpayers may be responsible for repaying these debts. In contrast, revenue bonds are secured by specific revenue streams generated from projects funded by the bond itself, such as tolls or utility fees. This distinction impacts how investors perceive risk; general obligation bonds may be seen as safer due to broader backing, while revenue bonds carry risks tied directly to the performance of the funded project.
• Evaluate the impact of changing interest rates on the valuation of municipal bonds and how this affects investor decisions.
  • Changing interest rates significantly impact the valuation of municipal bonds because bond prices move inversely to interest rates. When interest rates rise, existing municipal bond prices tend to fall as new issues offer higher yields. This fluctuation can influence investor decisions; for instance, rising rates may prompt some investors to sell their existing holdings to minimize losses or seek better returns elsewhere. Furthermore, investors must assess their tax situation and investment goals when navigating this volatility, considering how tax-exempt income from municipal bonds compares with taxable alternatives.

Related terms

General Obligation Bonds: A type of municipal bond that is backed by the full faith and credit of the issuing municipality, supported by its taxing power.

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

Tax-Exempt Status: The exemption from federal income tax on the interest earned from certain municipal bonds, making them appealing for investors in higher tax brackets.