Let’s say your city needs cash to build a new school or sewer system. The budget lacks funds and the state government is only willing to pay a small share. What does your city do? Most likely, it issues a municipal bond.
Munis, as they’re known, enable a state, county, city, housing authority or other local government to raise money for public projects — usually infrastructure. But unlike the bonds private firms sell to raise cash, the interest is free from federal income tax, meaning, in effect, that munis are federally subsidized. They are also often exempt from local taxes. These tax benefits allow issuers (also known as borrowers) to attract investors at lower rates; in financial parlance, it makes borrowing cheaper for local governments.
There are about 50,000 municipalities issuing notes and bonds in the United States, according to government regulators; outstanding munis were worth over $3 trillion in the first quarter of 2017. That number grew rapidly in the 1980s and 2000s. But it has changed little since the Great Recession, possibly reflecting “a hesitation to engage in new long-term capital projects given the budget challenges and economic uncertainties facing municipal governments,” according to a 2016 report from the Congressional Research Service, Congress’s nonpartisan think tank.
There are two types of munis: “general obligation,” which means the municipality pays the interest with regular tax revenues, and “revenue bonds,” for projects like toll roads or sewer systems, which generate income that can be used to pay the interest. General obligation bonds are secured on the faith and credit of the issuing government. That municipality pledges to tax its citizens, if necessary, to pay back the lender. Revenue bonds (a little more than half the market) are not guaranteed. If the toll road does not attract enough drivers, the lenders could lose money.
Selling munis involves a number of steps: For example, a city draws up a plan to borrow money to build a school. It hires a financial advisor who affirms a fiduciary duty to put the city’s interests first (and must register with federal regulators). The city then hires an underwriter who determines how much the bonds are worth, how many should be sold, and takes the risk of holding all the bonds lest they do not sell. For its services, the underwriter takes a commission. The underwriter sells the bonds through a brokerage firm (such as Fidelity or BlackRock), which takes a small percentage commission for pairing the bonds with investors — individuals, corporations or mutual funds, for example.
The bondholder (the investor) then receives regular payments. At the end of the life of the bond, he or she receives back the principal.
Regulators and data
The city posts information for buyers (investors) on the Electronic Municipal Market Access (EMMA) website, which offers real-time data, disclosure documents and bond prices. EMMA is run by the Municipal Securities Rulemaking Board (MSRB), a regulator overseen by federal bodies including the Securities and Exchange Commission (SEC) and empowered by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
Throughout the life of the bond, the city continues to update EMMA with information on its financial health. Meanwhile, investors trade the bonds on so-called “secondary markets” — trades that occur after the initial issuance, when bonds are often treated and traded like commodities.
The tax exemption for investors helps local governments raise money: “In most cases investors would be indifferent between taxable bonds (e.g. corporate bonds) that yield a 10 percent rate of return before taxes and tax-exempt bonds of equivalent risk that yield a 6.5 percent return. The taxable bond interest earnings carry a tax liability (35 percent of the interest income in most cases), making the after-tax return on the two bonds identical at 6.5 percent,” explains the Congressional Research Service. In other words, local governments pay 3.5 percent less than corporations to borrow money.
This adds up, costing Washington an estimated $31.7 billion in foregone tax revenue in 2016, according to the federal budget. That number is expected to grow in the coming years, though under Donald Trump’s proposed budget it would grow more slowly than under Barack Obama’s.
For anyone who does not pay taxes in the U.S., munis are not a sensible investment. Foreigners can generally get a better return in a corporate bond or a U.S. Treasury bill and don’t benefit from the muni tax break.
- Issuer – The municipality borrowing money; a.k.a. the borrower or the obligor. You can browse all the issuers by state inside the MSRB’s database. Dig a little and you can find what your local government has borrowed, at what rate, and all sorts of details on the municipality’s finances and creditworthiness inside each bond’s prospectus (example for Arlington, MA, here).
- Lender – The investor who loans money; a.k.a. the bondholder.
- Coupon – The annual interest paid on a bond, also known as the “coupon rate.” If a $1,000 bond pays $50 per year, the coupon rate is 5 percent. Because these payments are usually semiannual, that $1,000 bond at 5 percent will pay $25 twice per year.
- Yield – That’s the investment’s annual income. For our $1,000 muni at 5 percent, the yield is $50 per year. But, because bonds can be traded, that amount fluctuates depending on how desirable the bond is on the secondary market (see below).
- Maturity date – The date the municipality promises to pay back the principal. When these securities have maturity dates of less than one year, they’re known as “notes.” When the maturity is years away, they’re known as “bonds.” (A “security” is an investment intended to raise capital — generally, stocks and bonds are securities; bank accounts and futures contracts are not.)
- Primary market – Where newly issued securities are sold.
- Secondary market – The trading in bonds after they have been issued. Usually handled by a brokerage.
- Price – Richard Robb, who teaches capital markets at Columbia University, warns: “The expression ‘the price of a bond’ often leads to confusion. Bonds don’t have a single price. A dealer will bid at one price and offer at a higher price. ‘Price’ frequently refers to ‘mid-market.’ ‘Mid-market is the average of the bid and the ask prices.'”
- Default – When a borrower is unable to make a scheduled payment to a creditor. When this happens, the borrower usually files for bankruptcy protection to help negotiate with those creditors. When a default happens — think of Detroit and Puerto Rico — it makes big news. But muni defaults are far less common than corporate defaults, according to the MSRB. They occur 0.05 percent of the time compared to 2.73 percent.
For more, see the MRSB glossary.
Ratings agencies score a corporation or government’s ability and willingness to pay, though not every municipality will be rated by each of the agencies. The main three are Fitch, Moody’s, and Standard & Poors (S&P). Each uses its own scale and offers a credit rating, which the SEC calls “an assessment of an entity’s ability to pay its financial obligations.”
The muni market grew rapidly in the 1980s and the 2000s, this chart from the St. Louis Federal Reserve Bank demonstrates.
This 2016 report by the Congressional Research Service discusses all manner of bonds that local governments can sell to raise money for different types of projects, and the federal tax relevancy. It also describes bond-related tax provisions in recent legislation.
The Census Bureau collects data on state tax receipts. These do not include information on bond issuances, but can be useful for making relative comparisons.
For an explanation of the differences between ratings agencies’ methodologies, check out this piece by Reuters, written when S&P, but not the others, downgraded the U.S. government’s investment rating in 2011.