This content was originally published by Keygent Managing Member, Chet Wang.
When investors loan bond funds to a municipality, they are expecting a rate of return on their investment.
Unlike a mortgage where one bank loans the entire amount to a borrower, in a municipal bond financing there are typically multiple investors who loan funds based on their desired maturity length and other factors.
What is a maturity?
When a principal amount of a bond financing comes due, it “matures,” so this principal amount is referred to as a maturity.
Principal maturities are usually in minimum denominations of $5,000. A bond financing usually has multiple maturities that multiple investors can purchase. As an example, let’s say a $10 million bond financing has $500,000 in principal due annually in years 1 through 20. Year 1 may attract money market funds, or investors looking for a short-term investment. So Year 1 could have a money market fund purchasing $450,000 and a separate retail investor purchasing $50,000. Years 10 through 20 could have a large mutual fund buying all maturities for $5 million.
In the primary market, where a municipal bond financing is offered for sale for the first time (similar to a stock IPO), investors will place their order for bonds through the investment bank managing the sale (also known as the underwriter). The underwriter will then adjust the interest rates according to demand and allocate bonds to investors. Unsold balances are taken into the underwriter’s inventory to be sold at a later time.
In the secondary market, investors can purchase bonds from existing investors similar to buying stocks on a stock exchange.