A bond is a debt instrument, meaning that the issuer of the bond is borrowing a specified amount of money from you, often in multiples of $1,000. The issuer of the bond pays interest payments on the debt until the bond matures, at which point the investor cashes in the bond and receives their $1,000 back. Some bonds are callable, meaning the issuer can pay it back early if they choose.
A municipal bond, affectionately known as a muni, is issued by local, city or state government agencies to fund projects they do not have funds for in their budget, such as improving schools, roads and other public works projects. Most of them are exempt from local, state and federal taxes.
How to buy
When bonds are first issued, investors buy directly from the local, city or state government that is issuing it. From that point on, until the date of maturity, the bond can be resold on the bond market. The government agency must spend all of the money collected from the sale of bonds at once on the project the bonds were approved for within three to five years of the date of issuance of the bonds.
An investor is said to pay par when he purchases the bond at face value. The face value is the amount the bond was issued for, as written on the certificate, and what the bond holder will receive when the bond matures or is called-unless the issuer defaults on the loan. Investors can sometimes buy bonds at a discount, meaning they pay less for the bond than is on the face. They pay a premium if they pay more than the face value, which they might do if the interest rate is particularly attractive. No matter what they pay, they always receive the face value when the bond matures-although they may receive a small premium if the bond is called before the date of maturity. The date of maturity is set when the bond is issued.
The coupon rate of the bond is the annual interest rate the issuer will be paying to the bond holder-the higher the rate, the higher the interest payments. The coupon rate is set when the bond is issued and does not usually change. The interest can be paid monthly or quarterly, but most are paid semiannually. Depending on the type of project funded by the bonds, the interest may be exempt from local, state and federal taxes.
Types of Municipal Bonds
Municipal bonds can either be short term, maturing less than a year, or long term, which mature in longer than one year. Short-term bonds are either bond anticipation or tax revenue anticipation notes. Long term municipal bonds can be general obligation bonds, private activity bonds, revenue bonds or assessment bonds.
Safety as an Investment
Like all investment vehicles, Municipal bonds offer varying amounts of safety to the investor and nothing in the investment world is ever guaranteed. The government agency that issues the municipal bond does guarantee it, but the safety of the bond as an investment is dependent on the credit worthiness of that particular agency. A good way to determine the credit worthiness (and therefore the safety) of a bond is to look at its rating. If a third party risk rating agency grants a bond a BBB, Baa or better rating, experts will generally consider the bond to be a fairly safe investment. AAA-rated bonds are the safest, because they are fully insured by the agency that issued the bond. However, since they are the safest, they are also the lowest yielding.
Municipal bonds are not difficult to understand once you understand the basics, and they can be very conservative and worthwhile investments.