Municipal bonds

Definition

Municipal bonds are debt securities issued by states, cities, or other local government entities to raise funds for public projects. These projects can include the construction of schools, highways, or other infrastructure improvements, and they typically offer tax-exempt interest to investors, making them an attractive investment option. The funds raised through municipal bonds help municipalities finance their activities while providing a way for investors to support community development.

5 Must Know Facts For Your Next Test

1. Municipal bonds are typically classified into two categories: general obligation bonds and revenue bonds, each serving different funding needs.
2. The interest earned on municipal bonds is usually exempt from federal income tax and may also be exempt from state and local taxes for residents of the issuing municipality.
3. Investors in municipal bonds often include individuals seeking stable income and tax benefits, as well as institutional investors looking for diversified portfolios.
4. The creditworthiness of municipal bonds can vary widely based on the financial health of the issuing municipality, with ratings provided by agencies such as Moody's or S&P.
5. Municipal bonds can be a vital source of financing for local governments, enabling them to undertake significant public projects without imposing large tax increases.

Review Questions

• How do general obligation bonds differ from revenue bonds in terms of risk and repayment sources?
  • General obligation bonds are backed by the full faith and credit of the issuing municipality, meaning they are repaid through general tax revenues, making them generally lower risk. In contrast, revenue bonds are specifically tied to the income generated from a particular project, such as a toll road or a public utility, which introduces a higher level of risk since repayment depends on the project's success in generating revenue.
• Analyze the benefits and drawbacks of investing in municipal bonds compared to corporate bonds.
  • Investing in municipal bonds offers several benefits including tax-exempt interest income and lower risk due to backing from governmental entities. However, they may provide lower yields compared to corporate bonds which generally carry higher risk. Investors need to consider their tax situation and investment goals when choosing between municipal and corporate bonds, as well as the potential for growth versus stability.
• Evaluate how changes in economic conditions might impact the demand for municipal bonds and their attractiveness to investors.
  • Economic downturns can lead to increased demand for municipal bonds as investors seek safer investment options that provide stable income. However, if economic conditions improve significantly and interest rates rise, municipal bonds may become less attractive due to relatively lower yields compared to other investment options. Additionally, if municipalities face fiscal challenges during tough economic times, their credit ratings could drop, leading to higher perceived risks and potential declines in bond prices.

Related terms

General Obligation Bonds: Bonds that are secured by the full faith and credit of the issuing municipality, meaning they are backed by the issuer's taxing power.

Revenue Bonds: Bonds issued to fund specific projects that generate revenue, such as toll roads or public utilities, and are repaid from the income generated by those projects.

Tax-Exempt Income: Income that is not subject to federal income tax, often associated with the interest earned on municipal bonds.