Municipal bonds

Definition

Municipal bonds are debt securities issued by local governments or their agencies to finance public projects such as infrastructure, schools, and hospitals. These bonds are attractive to investors because the interest income is often exempt from federal taxes and sometimes state and local taxes, making them a popular choice for individuals seeking tax-advantaged investment opportunities.

5 Must Know Facts For Your Next Test

1. Municipal bonds are generally considered lower risk compared to corporate bonds due to the backing by government entities.
2. There are two main types of municipal bonds: general obligation bonds and revenue bonds, each serving different funding purposes.
3. Interest earned from municipal bonds is often exempt from federal income tax, making them attractive for investors in higher tax brackets.
4. The market for municipal bonds can be affected by changes in interest rates, credit ratings of municipalities, and overall economic conditions.
5. Investors should be aware that while municipal bonds offer tax benefits, they can also carry risks such as default risk or changes in state and local fiscal health.

Review Questions

• How do municipal bonds provide benefits to both local governments and investors?
  • Municipal bonds allow local governments to raise funds for essential public projects without raising taxes immediately. This financing method helps improve infrastructure, schools, and public services. For investors, municipal bonds offer a relatively safe investment option with the added advantage of tax-exempt interest income, making them particularly appealing to those looking to reduce their tax liabilities.
• Compare general obligation bonds and revenue bonds in terms of risk and funding sources.
  • General obligation bonds are backed by the full faith and credit of the issuing municipality and typically funded through tax revenues, making them less risky for investors. In contrast, revenue bonds are secured by specific revenue sources generated from projects like toll roads or utilities; thus, they may carry higher risk since their repayment depends on the project's success in generating income. Investors need to evaluate the funding sources and risks associated with each type when considering municipal bonds.
• Evaluate the impact of changing interest rates on the attractiveness of municipal bonds for investors.
  • As interest rates rise, newly issued bonds typically offer higher yields, which can make existing municipal bonds with lower rates less attractive in comparison. This could lead to a decrease in their market value. However, because municipal bonds often provide tax-exempt income, they may still appeal to investors in higher tax brackets even during rising interest rate environments. A careful analysis of an investor's overall financial situation and tax implications is crucial when assessing the continued attractiveness of municipal bonds under changing interest rates.

Related terms

Bond Yield: The return an investor can expect to earn on a bond, expressed as a percentage of the bond's face value.

Tax-exempt: Income that is not subject to taxation, often applicable to interest earned from certain municipal bonds.

General Obligation Bonds: A type of municipal bond that is secured by the full faith and credit of the issuing municipality, typically funded through taxes.