Municipal bonds are a great tool to help build an investment portfolio. For many investors, municipal bonds strike the perfect balance of relatively low risk and decent returns.
Not sure how municipal bonds work? This is the perfect post for you because it’s the first in a series of posts that cover all the basics about muni bonds, from the benefits of munis to the difference between stocks and bonds. In this article we will give you a general overview of municipal bonds.
The Basics of Bonds
In order to understand the nuances of municipal bonds, let’s review how bonds work in general. A municipal bond, also referred to as muni bond or simply muni, is essentially a loan issued by an entity in order to borrow money. When you buy a muni, you’re agreeing to lend the issuer (usually a city or state government) money for a predetermined period of time. In exchange, the borrower (that same city or state government) will agree to pay you interest, at a fixed rate, throughout the term of the bond. Once the bond matures, or comes due, your principal, which is the original loan amount, will be repaid to you in full.
You can make money from bonds in two ways:
- Collecting interest payments: most bonds pay interest semiannually, in which case you can expect income every six months.
- Selling the bonds at a premium before they come due: the value of bonds can fluctuate based on market conditions, so you may get an opportunity to sell your bonds for a price that’s higher than what you originally paid.
Municipal Bonds versus Corporate Bonds
Usually, when people talk about investing in bonds, they’re referring to corporate bonds. Corporate bonds are loans issued by corporations. A company might issue bonds to help pay for general expenses or raise capital for things like research, product development, and expansion. Corporate bonds are backed by the issuing company’s ability to repay them. Typically, this will come from ongoing operations and sales, though if a company has enough assets, those can be used as well.
Muni bonds, on the other hand, are government-issued bonds. They’re generally used to finance public projects and obligations such as school construction or airports and infrastructure-related repairs. With a municipal bond, the issuer—typically a city, town, or state—promises to pay a specific amount of interest over a fixed period of time, as well as return the principal investment amount once that period is over. In this regard, municipal bonds work just like corporate bonds.
Though municipal bonds offer many advantages over corporate bonds, which we’ll discuss in upcoming posts, corporate bonds are considerably more popular. According to the Securities Industry and Financial Markets Association, as of the fourth quarter of 2014, the total amount of municipal bonds outstanding was $3.65 trillion, while the total amount of corporate bonds outstanding was $7.84 trillion.
For further reading, check out our chapter on the difference between muni bonds and corporate bonds.
Types of Municipal Bonds
There are two types of municipal bonds:
- General obligation bonds, which are backed by the taxing power of the issuer.
- Revenue bonds, which are backed by the income generated by the projects they’re being used to fund.
General obligation bonds are generally considered to be safer than revenue bonds because the issuing party—again, usually a city or state—is essentially promising to use any means necessary to pay back its lenders. The issuer can use funding from any tax it collects to repay bondholders, and can even raise taxes as necessary if there’s a shortfall when its bonds come due. Think about the various taxes a city can collect: there are income taxes, sales taxes, and property taxes. All of these can be used to repay municipal bondholders.
Revenue bonds, on the other hand, rely on a specific income stream in order to repay lenders. Projects commonly funded by revenue bonds include highways and transportation systems, hospitals, and utilities. If, for example, a city issues revenue bonds to build a new bridge and charges motorists a toll for crossing it, the money collected from those tolls can be used to repay bondholders.
Credit Ratings, and What They Mean for Bonds
The greatest risk with regard to any type of bond investment is the possibility of default. A muni bond default is a failure on the part of the bond issuer (i.e. the city) to make a payment on time. A company or municipality is considered to be in default when it misses a scheduled interest payment, but the term can also apply to an issuer’s inability to repay the principal when it comes due.
Historically, municipal bonds have had a lower default rate than corporate bonds, and general obligation bonds have had a lower default rate than revenue bonds. That said, it’s important to get a good sense of the issuer’s creditworthiness and understand the risks before making the decision to buy its bonds.
A muni bond credit rating is a measure of an issuer’s creditworthiness and likelihood to repay its debts as scheduled. Factors such as assets, expenses, and growth opportunities are taken into account when determining a credit rating. There are three major rating agencies used to evaluate creditworthiness:
While S&P and Fitch use a similar rating system, Moody’s employs a slightly different one. Either way, the higher the credit rating, the safer a company’s bonds are considered to be:
- A rating of AAA from S&P/Fitch or Aaa from Moody’s means the bond issuer is extremely likely to repay its debts. This is the highest rating assigned to bonds.
- A rating of A+, A, or A- from S&P/Fitch or A1, A2, A3 from Moody’s means the issuer is highly likely to repay its debts, though less so than an issuer rated AAA or Aaa.
- A rating of BBB+, BBB, BBB- from S&P/Fitch or Baa1, Baa2, Baa3 from Moody’s means the issuer is still likely to repay its debts, but may have more difficulty than one with a higher rating.
Bonds rated BBB- or Baa3 or higher are considered investment grade, which indicates a generally low risk of default. Bonds rated below BBB- or Baa3 are typically referred to as junk bonds. While they tend to offer higher yields than bonds with higher ratings, they also come with a much greater risk of default.
While most bonds do have a credit rating, there are some that do not. This usually happens because the issuer either doesn’t want to pay for a rating, or hasn’t established enough of a credit history to attain one. If the bond you’re looking at isn’t rated, you can evaluate its risk by reviewing the issuer’s financial or disclosure statements. You can also try doing a simple search online and seeing if the issuer comes up in any news stories. From there, you may get a sense of how the issuer is faring.
Making Sense of Municipal Bonds
In this post we covered the basics of muni bonds, the difference between corporate bonds and muni bonds, and the background behind the credit rating agencies. In future posts we will write about the benefits and drawbacks of municipal bonds, compare municipal bonds to other investment choices, and walk you through some scenarios of why you might consider municipal bonds as a long-term investment strategy.