How Do Municipal Bonds Work;5 Facts

How Do Municipal Bonds Work.Municipal bonds were designed to finance public works. The money collected can be invested, for example, in building a new road.The authority that issued the bond must use the credit received according to the laws of its country. In some cases, the spending initiative is more constrained than in others. In addition, several filters are usually established to approve any large investment.

How Do Municipal Bonds Work.

Municipal bonds are debt securities issued by state and local governments or their agencies to finance public infrastructure projects such as schools, highways, and hospitals. Here’s how they work:

1. Issuance: Municipal bonds are typically issued by state and local governments through an underwriting process that involves investment banks and other financial institutions. The bonds are sold to investors, who provide the government with the funds to finance public projects.
2. Coupon payments: Municipal bonds pay interest to investors in the form of coupon payments. The interest rate, or coupon rate, is typically fixed at the time of issuance, and the payments are made semi-annually or annually.
3. Maturity: Municipal bonds have a set maturity date, which is the date when the bond issuer is required to pay back the principal amount to the bondholders. Maturity dates can range from a few months to several decades.
4. Tax-exempt status: One of the primary advantages of municipal bonds is their tax-exempt status. The interest income from municipal bonds is generally exempt from federal income taxes, and in some cases, state and local taxes as well. This makes municipal bonds particularly attractive to investors in high tax brackets.
5. Credit risk: Like any other bond, municipal bonds carry credit risk, which is the risk that the issuer will default on the bond and be unable to pay back the principal or interest payments. Credit risk varies depending on the financial health of the issuer and the credit rating assigned by credit rating agencies.
6. Secondary market: Municipal bonds can be bought and sold in the secondary market, which is the market for buying and selling securities after they have been issued. The price of a bond in the secondary market will depend on a variety of factors, including prevailing interest rates, credit risk, and market demand.

Characteristics of municipal bonds;How Do Municipal Bonds Work.

Among the characteristics of municipal bonds are:

• They offer a higher return than central government sovereign bonds. However, they are also riskier.
• Ideally, municipal bonds should be issued for the medium and long term. This, because they seek to solve projects with an extensive life cycle. If the bond period is very short, it may end even before the funded work can generate income.
• The conditions of the loan ( interest rateand terms) depend on the credit quality of the debtor. In other words, the solvency of the local authority that will carry out the issue. In addition, the destination of the financing received must be taken into account.
• It is important that the central government defines the functions, sources of income and an adequate system of accountability for local authorities. In this way, the credit ratingof the issuer (or potential debtor) of the municipal bond improves .
• They are instruments subject to political risk. That is, to the continuity in the decisions of the government. Likewise, the fiscal risk influences. In other words, the probability that the authority fails to meet its taxcollection , spending, and investment goals.
• The income received by holders of this type of bond may in some cases be exempt from payment of corporation tax.

Types of municipal bond

There are two types of municipal bond

• General Liability Bonds:They are backed by the debtor ‘s income , which in this case comes mainly from tax collection.
• Revenue Bonds:These are instruments earmarked for a particular initiative. Thus, the credit conditions depend on the expected benefits of the respective project and not so much on the history of the issuer.

municipal bond example

An example of a municipal bond is the one launched by Bogotá in 2001. The nominal value of the issue was US$100 million at an annual interest rate of 9.5% for a period of five years.The objective of the operation was to finance infrastructure projects in the Colombian city. Regarding the risk of these bonds, it is known that they received, for example, a BB+ rating from the Fitch Ratings agency.