Municipal bonds

Definition

Municipal bonds are debt securities issued by local government entities, such as states, cities, or counties, to raise funds for public projects like schools, highways, and hospitals. They are often favored by investors due to their tax advantages, as the interest income earned is typically exempt from federal income tax and, in some cases, state and local taxes as well.

5 Must Know Facts For Your Next Test

1. Municipal bonds are generally considered lower-risk investments compared to corporate bonds because they are backed by government entities.
2. Interest from municipal bonds is often exempt from federal taxes, making them attractive to investors in higher tax brackets.
3. There are two main types of municipal bonds: general obligation bonds and revenue bonds, each serving different purposes for funding public projects.
4. Investors should be aware that while the interest is tax-exempt at the federal level, it may still be subject to state or local taxes depending on the investor's residency.
5. The market for municipal bonds can be influenced by factors such as changes in interest rates, economic conditions, and the financial health of the issuing municipality.

Review Questions

• How do municipal bonds provide tax advantages to investors compared to other types of bonds?
  • Municipal bonds offer significant tax advantages because the interest earned on them is usually exempt from federal income tax. For investors in higher tax brackets, this exemption can lead to a higher effective yield compared to taxable bonds. Additionally, if the investor resides in the state where the bond was issued, they may also avoid state and local taxes on the interest, further enhancing their attractiveness as an investment option.
• Discuss the differences between general obligation bonds and revenue bonds in terms of their backing and intended use.
  • General obligation bonds are backed by the full faith and credit of the issuing municipality and are typically funded through taxpayer revenue. They are used for essential public projects that benefit the community broadly. In contrast, revenue bonds are secured by specific revenue sources generated from a project, like tolls from a highway or fees from a public utility. This means that their repayment relies solely on the revenue produced by those projects rather than general tax revenues.
• Evaluate the impact of interest rate changes on the market for municipal bonds and investor behavior.
  • Interest rate changes have a significant impact on municipal bonds' market performance and investor behavior. When interest rates rise, existing municipal bonds with lower rates become less attractive compared to newly issued bonds offering higher yields. This can lead to a decrease in bond prices as investors seek better returns elsewhere. Conversely, when interest rates fall, existing municipal bonds become more valuable since they offer higher yields than new issues. Investors may then flock to municipal bonds for their tax-exempt income potential, increasing demand and driving up prices.

Related terms

Tax-Exempt Income: Income that is not subject to federal income tax, often associated with certain types of investments, including municipal bonds.

Bond Rating: An assessment of the creditworthiness of a bond issuer, which affects the interest rate and risk associated with a bond; higher ratings indicate lower risk.

General Obligation Bonds:

A type of municipal bond backed by the full faith and credit of the issuing municipality, funded by taxes and other revenue sources.