What Are Municipal Bonds?
/When investors are looking for potential investments, they may consider municipal bonds as an option –but what are they? Municipal bonds are financial instruments that allow investors to support local communities while earning a stable return on investment. Many do not fully understand how municipal bonds work, but Keygent is here to help.
Municipal bonds, sometimes referred to as "munis," are debt financings issued by states, cities, counties, or other local government entities to raise funds for public projects or infrastructure development. These projects could include building schools, hospitals, highways, or providing essential services that benefit the local community, such as fire departments. California school and community colleges may issue municipal bonds to finance new construction or renovate existing buildings. When investors purchase municipal bonds, they are essentially lending money to a government entity.
The two most common types of municipal bonds in California are:
1. General Obligation Bonds
- These bonds are typically repaid by ad valorem taxes levied by state or local governments.
2. Revenue Bonds
- These bonds are typically repaid by the revenue generated by the project, such as tolls from a toll road.
Municipal bonds offer several advantages to investors such as:
1. Tax-Exempt Interest
- Typically interest income from municipal bonds is exempt from federal income tax and in some cases may also be exempt from state and local taxes.
2. Low Default Risk
- Municipal bonds are considered relatively safe investments due to historically low default rates compared to other debt instruments. This is generally the result of the ability of local governments to generate unlimited ad valorem tax revenue or increase fee revenues to repay the financing.
3. Stable Income Stream
- Municipal bonds generally have interest payment schedules that include semi-annual or annual interest payments, which is desirable for investors seeking a predictable cash flow.
Municipal bonds also have some disadvantages such as:
1. Interest Rate Risk
- Municipal bonds are subject to fluctuations in interest rates. Munis have an inverse relationship with interest rates meaning when interest rates rise, the value of municipal bonds typically decline, and if interest rates decline, the value of municipal bonds typically increase.
2. Market Liquidity
- Municipal bonds are generally less liquid than stocks, which means they may be more challenging to buy or sell.
Investors may purchase individual municipal bonds directly through a broker or financial institution or may invest in mutual funds that have municipal bond holdings. Investors sometimes elect to purchase a mix of stocks and bonds in order to create a diversified portfolio. Municipal bonds are generally considered a safe investment option that also provides investors a way to contribute to the development and well-being of their local community.
Keygent LLC is based in El Segundo, CA and specializes in providing municipal advisory services to California school and community college districts, including the issuance of municipal bonds to finance their capital needs. For more information, please contact us.