The bond market is the largest public securities market in the world, and substantially larger than the stock market. When investors allocate assets in their investment portfolios, oftentimes those in higher tax brackets will opt to use municipal securities for an added tax benefit.
What are municipal bonds?
A municipal (or “muni”) bond, like any other bond or fixed-income investment is a debt instrument. You, as the investor, loan your money to the issuer for a stated period of time at a specific interest rate. The single biggest difference with the muni market is the potential for tax-free income. A municipal bond is generally issued as a debt instrument offered by a State, City, County or Local Municipality. The assets collected are used to finance things such as schools, highways, bridges, and various other projects that require funding. They may also be financing the general budget of a municipality.
Generally speaking, income derived from a municipal bond is free from Federal income taxes. Should you live in a state or city that assesses an income tax, if the bond was issued by a municipality in the state you reside in for income tax purposes, it will typically be exempt from State/City income tax as well. If you reside in a state that does not levy an income tax, the Federal exemption on the income applies regardless of which state you purchase the issue from.
General Obligation vs Revenue Bonds
Muni bonds break down into two broad categories with many sub-categories. The first of which is the general obligation bond, which is exactly what it sounds like. The issue is not financing for any single project of the municipality. Rather it is backed by the full faith and credit of the municipality and is funding the municipality’s general obligations.
The revenue bond is a bit different. In general they are financing for a specific agency of that municipality. For example, should you purchase a bond that was designed to cover the financing of a new bridge, and the bridge collapsed, the ability for you to redeem your funds could potentially be in jeopardy, as tolls are no longer being collected. However under such a circumstance, the state or city may still be in excellent fiscal condition with no impairment to its ability to repay its other debt obligations. It is for this reason revenue bonds are typically viewed as carrying more risk, which in turn can offer a higher interest rate to compensate for the added risk.
In the case of municipal bonds, there can be other avenues of added protection that you may want when buying an issue. One such feature is insurance. Unlike the Federal government, a municipality cannot simply create more money when there is a budget shortfall or whenever it sees fit to do so. It is certainy not impossible for a local municipality to go bankrupt. While this is a fairly rare occurrence, it has happened. The bond issuer can issue these debt instruments with an added layer of insurance against a default by a private insurer. There are a relatively small number of companies that specialize in this type of insurance.