What are muni bonds?
These are bonds issued by a state, city, county, local government, or one of their agencies (like a school district or airport).
How are muni bonds issued?
The process for issuing corporate bonds is similar to issuing stock. An investment bank (or a group of investment banks forming a syndicate) underwrites the bond offering by buying the bond offering and re-selling them to investors. Government bonds, on the other hand, are typically auctioned off.
Why are muni bonds issued?
Just like Treasury bonds, municipal bonds are issued by states, cities, and counties, or their agencies to raise funds for various projects.
Types of muni bonds
- General obligation bonds. General obligation bonds, or "G.O. bonds" for short, are generally issued for projects that don't generate revenue (like schools). Because there is no revenue generated, these bonds are backed by the credit of the issuer as opposed to being attached to a specific revenue stream or assets. This means the state or municipality can use tax dollars to pay back the bonds. Because of this, general obligation bonds are viewed as being safer than (and have higher ratings than) revenue bonds. But they also tend to pay a lower yield since the default rate is considered to be lower.
- Revenue bonds. These bonds make up the majority of muni bonds. These bonds are issued to fund projects that produce income (like public housing or toll bridges) and they are backed up by the income stream from that project. They are not backed by the general credit of the issuer and therefore are not secured by taxes. They tend to have higher yields than G.O.s because of their higher default risk.
Why do people buy muni bonds?
Interest received by holding municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued.
Because muni bonds are often exempt from taxes it is useful to calculate the yield a muni bond would give if you were paying taxes on the income. To do this, simply divide the stated yield by 1 minus your marginal tax rate. An example is below.
/ (1 - tax rate)
= 5% / (1 - .28)