British Columbia Sun

Wednesday, November 29, 2023

What is a municipal bond and how does it work?

Municipal bonds, also known as “munis,” are debt securities issued by state and local governments or their agencies to raise money for public projects. These projects may include schools, hospitals, highways, airports, water and sewer systems, and other infrastructure projects.

Municipal bonds are typically exempt from federal taxes, and in some cases, state and local taxes as well. This tax advantage makes them attractive to investors seeking tax-free income. The interest rate on municipal bonds is generally lower than other bonds, such as corporate bonds, because of this tax benefit.

There are two types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith and credit of the issuing government, which means that the government is legally obligated to repay the bondholders, even if it means raising taxes or cutting other services. Revenue bonds, on the other hand, are backed by the revenue generated by a specific project, such as tolls on a bridge or revenue from a sports stadium.

Municipal bonds are sold through a competitive bidding process, where underwriters submit bids to the issuer with the lowest interest rate. The underwriter then resells the bonds to investors at a slightly higher price, earning a profit on the difference. Municipal bonds are typically sold in denominations of $5,000 or $10,000, making them accessible to individual investors.

When an investor buys a municipal bond, they are lending money to the issuing government or agency. The bond has a stated maturity date, which is the date when the principal is due to be repaid. The bond also has a stated interest rate, which is the amount of interest paid to the bondholder annually.

Municipal bonds are typically considered to be a low-risk investment because they are backed by the full faith and credit of the issuing government or agency. However, like all investments, there is still some level of risk involved. The risk of default varies depending on the creditworthiness of the issuer, which is determined by credit rating agencies such as Moody’s or Standard & Poor’s.

If the issuer defaults on the bond, bondholders may face losses or delays in receiving their principal and interest payments. In the event of a default, bondholders may take legal action against the issuer to recover their investment.

Municipal bonds can be bought and sold on the secondary market, which is where investors can buy or sell bonds to other investors before the bond’s maturity date. The price of a bond on the secondary market is determined by market forces such as supply and demand, changes in interest rates, and the creditworthiness of the issuer.

Investors who hold municipal bonds to maturity will receive the full principal amount, as long as the issuer does not default. If the bond is sold on the secondary market before its maturity date, the investor may receive more or less than the original principal amount depending on market conditions.

In conclusion, municipal bonds are a type of debt security issued by state and local governments or their agencies to fund public projects. They offer a tax advantage to investors seeking tax-free income, and are typically considered a low-risk investment. However, like all investments, there is still some level of risk involved, and investors should carefully consider the creditworthiness of the issuer before investing in municipal bonds.

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