What is a 'Municipal Bond'?

Written by PaayiAdmin |01-Aug-2020 | 0 Comments | 418 Views

The debt issues of state and local government units are called municipal bonds. Interest on such bonds is exempt from federal income taxes, which means that the "municipal bonds" can be sold at interest rates lower than those paid by business firms and often less than those paid by the federal government itself.


Three main types of municipal bonds are available.

General Obligation Municipal Bonds

General Obligation Municipal Bonds are backed by the total taxing power of the government until that issues them.

Now take an Example of some town of U.S.A called Woodlands. Woodlands is a great place to live; there are attractions, good schools, and the high business environment. It's no wonder that many families moved here.

But with a sudden increase in the number of families are living in Woodlands, there is no space available in the school for new students.

The Mayor, the town council, school district leaders all agreed that they need a brand new school is woodlands. In addition to the expansions to the existing school buildings. But at an estimated cost of $25 Million.

Now the question arises that how the woodlands are going to pay $25Million. The leaders of Woodlands comes up with a plan that they raise funds by issuing bonds.

It means that now Woodlands can borrow $25Millions from the investors with the expectation of paying them back with interest over a specified period.

The people who live in the Woodlands & use the school's property in future will also be the people's paying for this. Woodlands will use property tax revenue to repay the investors back this is called General Obligation Municipal Bonds.

But this is just the Idea how they generate money for the new school building. To get this done with real voter approval is required. So Bond proposal is developed and gone for voting. If bond gets the majority of yes votes, it PASSES.

Now is this bond is PASSED, new characters come on the scene, The Underwriter, Bond Counsel & Financial Advisor.

Financial Advisor talks to the Woodlands & helps to make decisions regarding the Bonds. The Financial Advisor works with Underwriter to determine the pricing & distribution to the Investors. Then Underwriter takes that bond to the potential Investors.

You can choose your Underwriter by two ways:-

  • Competitive sale of the Underwriter
  • Negotiated Sale of the Underwriter

So Town Council of Woodlands wants to go by Competitive sale and put the Bond out to Bid.

The Bond Council Paayi Law Firm prepares the bond documents including all official statements. Since Woodlands Choose the competitive route, they want notice of sale. The official statement contains every bit of information that prospective investor needs to invest in the Woodlands Bonds.

Now Paayi Law firm sends this official statement to Underwriter & then Underwriter will review the official statement & decide he wants to bid on the bond.

Bond Council Paayi Law Firm also writes the legal opinion which provides full justification for tax-exempts & ensures that these Woodland's bonds are valid and binding obligations with Woodlands.

The company does not comment on the merit of the bond. When this legal opinion is completed, then Notice of Sale comes in the picture.

Paayi Investment Bank see's the Ad and interested in underwriting with the goal in mind of buying the Woodland Bonds and reselling it to their investors.

Before Submitting the bid to the Woodland's, they would like to invite the other leading investment banks to participate in buying Woodland's bonds. Paayi Investment Bank wants to form a Syndicate and act as a Syndicate Manager.

Forming a Syndicate will allow the Paayi Investment Bank to share the marketing & distribution duties, Also some of the financial risks of underwriting the Woodland bonds.

Three Banks ABCD Bank, Online Bank, Relish Bank, agrees to join syndicate & they submit the bid. Now Woodland's town council review the proposal along with several other things for consideration.

After the review, the Bond is awarded to the syndicate formed by Paayi Investment Bank because they give the lowest borrowing price.

Now syndicate works as an underwriter and reaching out to Individual buyers, Institutional investors, and check their interests in buying the bonds.

Investor -  Dinesh is Woodlands resident & decided to purchase some Municipal Bonds. He heard about it and excited to buy it. Dinesh as a potential investor knows how important it is to be informed about the investment options.

Dinesh obtains the copy of the Municipal Bond preliminary official statement from his brokerage firm. He carefully examines the terms of the municipal bonds and financial situations of Woodlands.

After a thorough review, Dinesh decides to purchase $25000 worth of the municipal bonds. Dinesh submits an indication to his brokerage firm. Entering an order of $25000 makes Dinesh only eligible for allocation of bonds. It's not a guarantee that he can purchase the bonds, the offering me be oversubscribed. He could get a portion of the bonds requested, not everything that he requested.

Once the Woodlands bonds allocated by the underwriting syndicate, Dinesh will receive a notification. Then he confirms the indication of interest to move forward with the purchase.

Full allocation, $25000 worth of Municipal Bonds then placed in his account. Finally, Dinesh receives written confirmation of the transaction and copy of Woodland's final official statement, which includes the final yields on the bond issue. By this way our investor's transactions are complete.

Now see What's going on in Woodlands, Paayi Investment Bank provides woodlands proceeds from the bond sale. It's important to know that these funds can only be used for the school project. From this point in school, construction officially begins.


Revenue Bonds

Revenue Bonds are related to specific projects from which the interests and principal are to be paid. Revenue bonds may finance particular sections of highways. Interest and principal are then repaid from tolls charged for the use of the roads.

Investing in bonds, there so many types from which you can choose. But if you are interested in that kind of investment which pays you the proper amount of interest and has remarkable potential tax advantages, then you might consider Municipal Revenue Bond. 

Imagine Woodlands City has undergone tremendous residential development and population growth. Till now, water & sanitation has been brought in from a larger city close by.

Now city officials determine that based on the growing population water needs it may be more cost-effective for the woodlands to treat its pool than to pay extra for importing the water from the larger city.

For this to achieve Woodlands, need their water facility, which will require a tremendous amount of funds & Woodlands currently doesn't have that much amount of resources.

So Woodlands have one option to raise the amount what they needed for the new water plant is to issue a Municipal Revenue Bond. Revenue Bonds are issued by cities & counties to help & fund projects for the advancement & betterment of the city.

Like Highways, Water plants, constructions, bridges, tunnels, etc. They pay back solely by the fees or revenue that can be generated by the project and collected by the issuer of Woodlands city.

In our Example of Water Plant, Interest and repayment of the debt will be funded by the revenue of the water facility generate called water bill. City residents will require paying this amount each month.

After municipality issued, the municipal revenue bonds. They are easily available for ordinary people to purchase on the secondary market.

Municipal Revenue bond can be purchased from a brokerage firm or securities dealer for a minimum investment typically only $5000 plus commissions or markups.

Like other obligations, obtain a municipal revenue bond you are in effect lending you money to issuing entity. Who agrees to return it at maturity, in exchange for lending you money you may receive interest twice a year.

Unlike other bonds such as corporate bonds, there may be special tax considerations regarding the interest earned on municipal revenue bonds.

In case you are living in the state and city issuing the bond you may also be exempt from income taxation on the bond interest on those levels. So municipal revenue bonds carry these kinds of unique tax advantages they may offer lower interest rates than corporate bonds, etc.

Please visit any tax professional to get more knowledge on tax implications on bonds, before making any investment on any kinds of bonds.


Risks in Investing in Municipal Revenue Bonds

All bonds are subject to default risks. Suppose the population of the woodlands city decreases in coming years then issuer may not receive sufficient revenue to make its payments on the bonds. These two ways can cover this kind of risks.

  1. Before Investing Please check the credit rating of the Issuer.
  2. Some Municipal securities covered by bond insurance - Which help guards  against this risks

Insurance Bonds are underwritten by the private insurer that will guarantee the payment if issuer can't. Revenue Bonds are less liquid as compare to stocks & don't trade as actively as corporate bonds.

Municipal Revenue bonds were much more sensitive to supply and demand to subject them to the elevated level of market risk when it comes to buying and selling.


International Development Bonds

International Development Bonds are used to build plants to attract business firms to a local area. The business enterprises that occupy such plants pay rent that is used to pay off the interest and principal on the bonds. The tax-exempt feature of the bonds enables the local government to subsidize business firms with low-costing financing.


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