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Municipal bonds are issued by a municipal government agency, or subdivision thereof (the issuer, for the purpose of raising funds. The methods and practices of issuing debt are governed by an extensive system of laws and regulations, which vary by state.
The issuer of a municipal bond receives a cash payment at the time of issuance in exchange for a promise to repay the investors who provide the cash payment (the bond holder) over time. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer.
The issuer typically uses proceeds from a bond sale to pay for projects it cannot or does not desire to pay for immediately with funds on hand. Laws governing municipal bonds typically require all money raised by a bond sale to be spent on one-time capital projects (as opposed to operations and maintenance ongoing expenses) within three to five years of issuance.
Because of the special tax-exempt status of most municipal bonds, the market usually accepts lower interest payments than on other types of borrowing (assuming comparable risk). This makes the issuance of bonds an attractive source of financing to many governmental agencies, as the borrowing rate available on the open market is frequently lower than what is available through other borrowing channels.
Municipal bonds are one of several ways a muncipal government can issue debt. Other mechanisms include certificates of participation and lease-buyback agreements. While these methods of borrowing differ in legal structure, they typically act similarly to municipal bonds as described in this article.
Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an upfront investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself (see Bond).
Repayment schedules differ with the type of bond issued; the issuer may make equal amortized interest and principal payments every six months, may make only interest payments until the bond matures and then repay the entire principal amount, make one lump-sum payment at maturity, or some mix of these options.
The interest income on a municipal bond may be tax-exempt. This makes municipal bonds an attractive investment to certain investors, and results in investors accepting a lower interest rate on their investment than they would on a taxable investment of equivalent risk.
One of the primary reasons municipal bonds are considered separately from other types of bonds is their special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is exempt from all federal taxes, as well as state taxes for the state in which the issuer is located, subject to certain restrictions.
The type of project or projects that are paid for by a bond affects the taxability of income received on the bonds by bond holders. Bonds funding projects that are constructed for the public good are generally tax free, while bonds issued to fund projects partly or wholly benefiting only private parties may be taxable.
The laws governing the taxability of municipal bond income are complex; however, bonds are typically certified as either tax-exempt or taxable before they go up for sale on the market. Purchasers of municipal bonds should be aware that not all municipal bonds are tax-exempt.
The security of a municipal bond is a measure of how likely the issuer is to make all payments, on time and in full, as promised in the agreement between the issuer and bond holder (the bond documents). Different types of bonds carry different securities, based on the promises made in the bond documents:
In addition, there are several other types of municipal bonds with different promises of security.
The probability of repayment as promised is often determined by an independent reviewer, or rating agency. The three main rating agencies for municipal bonds in the United States are Standard & Poor's, Moody's, and Fitch. These agencies can be hired by the issuer to assign a bond rating , which is valuable information to potential bond holders that helps sell bonds on the primary market.
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