(Reuters.com) - The municipal bond market is the main credit market for state and local governments in the United States. It's a $2.7 trillion market that is attractive to investors because interest income is exempt from federal income tax, and in some cases from state and local income taxes as well. Municipal bonds allow investors to invest in state and local government projects, including schools, highways, hospitals, airports, housing, sewer systems and other public projects.
How do municipal bonds compare with other fixed-income products?
Municipal bonds historically are of high credit quality because state and local governments have much lower default rates than corporate bond issuers. Many municipal securities are highly rated by the credit agencies -- Moody's Investors Service, Standard & Poor's and Fitch Ratings. In the past, many issues were also backed by triple-A-rated municipal bond insurance, although the major insurers have lost their top ratings in the past year due to exposure to subprime mortgage losses and that has undermined their business model.
The main appeal of munis is their tax-exempt status which makes them attractive even if yields are usually lower than for comparable taxable securities. Taxes reduce the net income on taxable bonds so investors compare the two using taxable equivalent yields, which measure what a taxable security would need to yield to provide the same after-tax yield as a comparable municipal security.
What are the main types of municipal bond?
There are two main structures for the municipal bond market; general obligation bonds and revenue bonds. General obligation bonds, or GOs, are backed by the full faith and credit of a municipal government, including the support of its entire taxing power. Revenue bonds are secured by a pledge of specific revenue sources, usually the earnings from a specific tax or a project. There are short and long-term maturities and municipal bonds offer fixed and floating interest rates. Interest on the majority of securities in the market are paid on a semiannual basis.
Other popular securities include:
* Certificates of Participation which are repaid from appropriations made by a state or local government to a third party.
* Revenue anticipation notes, which are a short-term form of borrowing that is repaid from a future cash flow.
* Tax anticipation notes, which are to be repaid from taxes that will be collected in the future.
* Bond anticipation notes, which are repaid using the proceeds of a long-term issue.
The federal government allows for tax-exempt financing for nonprofit entities such as hospitals, private universities and museums, as well as for private uses, such as housing, student loans and business development. States and local governments can also tap the taxable market for certain types of projects and to replenish pension funds. Taxable municipals are closest to corporate or agency debt and are taxable at the federal level.
What are the main risks associated with municipal bonds?
Like other fixed-income securities, municipal bonds carry interest rate risk, or the risk that they will lose value if interest rates rise. There is also the possibility that interest rates fall, boosting the value of municipal bonds. The bonds also carry inflation risk which can eat into the value of interest payments. Reinvestment risk refers to the risk that an issuer will call the bond before the maturity date, which may force the investor to reinvest at lower rates.
Municipal bonds also have liquidity risk as it is an over-the-counter market that is not as widely traded as taxable bonds. However, wide ownership by institutional investors and retail investors mitigate that risk. There is also credit risk if a state or local government defaults on its debt.
