What it means
Public bodies use bonds for the same reason businesses do, which is to match the cost of a long lived asset to the years in which it is used. A bridge that lasts forty years is fairly financed over decades rather than out of a single year's tax receipts.
Issues come in two families that carry very different risk. General obligation bonds are secured by the issuer's power to levy taxes, while revenue bonds are repaid solely from the earnings of the project they financed, so their safety depends on that project performing.
Credit quality is assessed by rating agencies in the same way as corporate debt, and pricing follows those ratings closely. A highly rated state issuer will borrow far more cheaply than a small authority with a stretched budget and an ageing tax base.
For the investor, the practical attractions are predictable income, a tax exemption that is worth most to high earners, and a historically low default rate. The practical drawbacks are modest yields, long maturities and thin trading, since many issues are small and rarely change hands.
Prices move with interest rates like any bond, so a long dated municipal bond can lose considerable market value if rates rise. That only matters if the holder needs to sell, because an investor who holds to maturity receives the face value regardless of what happened in between.
In practice
Real-world examples.
Example
A county issues $75 million of general obligation bonds over twenty five years to build three schools, backed by property tax receipts. Because the county holds a strong credit rating, it borrows at roughly one percentage point below what a similar sized corporate issuer would pay.
Example
A regional airport authority funds a new terminal with revenue bonds repaid from landing fees and parking income. Investors demand a wider yield than on general obligation debt because passenger numbers, not tax powers, determine whether they are repaid.
Example
A retired couple builds a ladder of municipal bonds maturing in each of the next ten years. The staggered maturities give them predictable tax free income and return capital regularly, so they are never forced to sell into a weak market.
Think of it
“Muni bond is state or local government debt-usually tax-free interest.
Formula
Calculation
Annual interest = face value x coupon rate
After tax income from a taxable alternative = face value x coupon rate x (1 - marginal tax rate)
An investor with $50,000 to place is choosing between a municipal bond with a 3.8% coupon and a corporate bond with a 5.0% coupon, and pays tax at 32%. The municipal bond pays $50,000 x 0.038 = $1,900 a year, and because the interest is exempt the investor keeps the whole $1,900.
The corporate bond pays $50,000 x 0.05 = $2,500 a year, but tax of $2,500 x 0.32 = $800 leaves $2,500 - $800 = $1,700. The municipal bond therefore delivers $1,900 - $1,700 = $200 more spendable income each year despite the lower coupon, which over a ten year holding is $2,000 of extra income on the same capital.Case study
Seen in the real world.
What follows is an illustrative and clearly fictional example. The invented town of Harper's Crossing needed $18 million for a water treatment upgrade and its council debated two routes: a general obligation issue backed by property taxes, or revenue bonds repaid from water charges.
The fictional finance officer laid out the trade off plainly. General obligation bonds would price about 0.7 percentage points cheaper because they were backed by taxing power, saving roughly $126,000 of interest a year, but they would use up borrowing capacity the town wanted to keep for a planned school project.
Harper's Crossing chose revenue bonds and paired the issue with a modest scheduled increase in water charges so that coverage stayed comfortably above the level investors expected. The higher interest cost was accepted as the price of keeping its general obligation capacity free.
Watch out
Common mistakes.
- Assuming every municipal bond is effectively risk free because the issuer is a public body, when revenue bonds depend entirely on one project's income.
- Ignoring the effect of interest rate moves on long dated issues, which can produce large paper losses for anyone who needs to sell early.
- Buying municipal bonds for a low rate taxpayer, who gives up yield in exchange for an exemption worth very little to them.
Questions
People also ask.
What is the difference between a general obligation and a revenue bond?
A general obligation bond is backed by the issuer's taxing power, while a revenue bond is repaid only from the income of the specific facility it financed.
Do municipal bonds ever default?
It happens, though far less often than in corporate debt, and defaults cluster in small revenue issues rather than in large general obligation borrowings.
How does someone actually buy them?
Most private investors use a municipal bond fund for diversification and easier trading, while larger portfolios buy individual bonds through a broker.
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