Municipal bond definition

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What is a Municipal Bond?

A municipal bond is a debt security that has been issued by a local government entity. Examples of these issuers are state, county and city governments. Municipal bonds are commonly used to fund the construction of roads, schools, airports, hospitals, wastewater treatment facilities and other infrastructure projects.

Advantages of Municipal Bonds

The interest income that an investor receives from a municipal bond is exempt from federal taxation and may also be exempt from taxation at lower levels of government. This tax exemption makes municipal bonds an especially attractive investment for individuals with a high incremental tax rate.

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Disadvantages of Municipal Bonds

A key disadvantage of municipal bonds is that smaller investors tend to be excluded from this market; this is because most municipal bonds are issued in minimum denominations of $5,000. Given this threshold amount, most investors tend to be wealthy private investors or institutional investors.

Types of Municipal Bonds

The main types of municipal bonds are described below:

  • General obligation bonds. These bonds are backed by the full faith and credit of the issuing municipality, which means they’re supported by the issuer’s taxing power. They are typically used to fund public projects like schools, roads, and parks. Because repayment is secured by tax revenues, they’re considered low-risk for investors.

  • Revenue bonds. These bonds are repaid from the income generated by specific projects or sources, such as toll roads, utilities, or airports. They are not backed by the government’s taxing power, making them riskier than GO bonds. Investors rely on the success of the revenue-generating project for repayment.

  • Tax anticipation notes. These notes are short-term municipal bonds issued in anticipation of future tax collections. They help governments manage cash flow before actual tax revenues are received. Once taxes are collected, the municipality repays the note.

  • Revenue anticipation notes. These notes are similar to tax anticipation notes, but are backed by expected revenues other than taxes, such as federal or state aid. They provide short-term liquidity until the anticipated funds arrive. These notes are typically repaid within a year.

  • Bond anticipation notes. These notes are short-term securities issued ahead of a longer-term bond issue. They are used to finance projects temporarily while the issuer arranges for permanent funding. Once the long-term bonds are sold, proceeds are used to repay the notes.

  • Certificates of participation. These certificates are a form of lease-financing where investors purchase shares in the lease revenues of a program or facility. Unlike traditional municipal bonds, they don't require voter approval. They offer a creative way for governments to fund projects without directly issuing debt.

  • Private activity bonds. These bonds are municipal bonds that are issued to finance projects for private entities, like hospitals, airports, or industrial parks. Though they serve public purposes, the benefit goes largely to a private party. Some PABs may not be tax-exempt, depending on their use.

How Municipal Bonds Are Priced

The market price of a municipal bond will vary with changes in the market interest rate. As the market rate increases, the value of a municipal bond will decline. Conversely, if the market rate declines, the value of a municipal bond will increase.