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Municipal Bonds 101

Safety and tax exemption are traditional hallmarks of the asset class, but the market has many challenges.

Jeff Westergaard, 08/28/2012

The municipal-bond market is one of the mainstays of fixed-income markets for U.S. investors. Muni bonds provide the means by which state and local governments and charitable organizations raise capital to fund all manner of needs. For investors, munis offer two primary benefits: low default occurrence and interest that is usually exempt from federal taxation.

In addition, the market is characterized by its incredible diversity of both issuers and individual bonds. There are more than 100,000 unique issuers and 1.5 million individual bonds outstanding, staggering numbers in relation to any other securities market. Taken together, these aspects make the muni-bond market unique among investable asset classes. Here’s a primer on the muni-bond market.

A Promise to Pay
Municipal bonds are debt instruments, meaning that the municipal issuer is borrowing money from the bond investor. The issuer stipulates the amount of interest to be paid, the date at which principal will be repaid, and the conditions that will be employed to provide security of repayment. All of these are determined at the time of issuance and are codified in an offering document called the official statement. The means by which any given muni issuer can provide payment security covers a wide range and, for state and local government issuers, will be determined by what the state legal code allows. At a broad level, these means of repayment are usually categorized as being one of the following:

  • General obligations: a promise by the issuer to treat the debt obligation as payable from any legally available source, in the case of local governments often from property tax revenues.
  • Revenue bonds: bonds secured by specifically assigned sources of payment, often times from business like enterprises, such as a water or sewer system.
  • Leases/certificates of participation: bonds or fractional ownership interests in lease payments made by an obligor, including administrative buildings, correctional facilities and university buildings.

The market generally considers general-obligation bonds to be the least risky category. Overall, though, the level of defaults for munis historically is low, many orders less than those of corporate bonds.

Municipal-Bond Issuers
Issuers, or more correctly “obligors,” fall into one of three categories: state and local governments; charitable organizations; or private activity organizations.

The first category includes states and their agencies, cities, counties, towns, school districts, and special districts such as parks or utilities. It is the largest category both in terms of issuers and of bonds outstanding.

Charitable organizations consist primarily of hospital and educational organizations that are designated as nonprofit. This is a large compo- nent of the municipal market with significant amounts of bonds outstanding.

Private activity bonds are paid by entities that generally exist to make commercial profits such as corporations. The usual type of issues in this category is for economic development or pollution control purposes.

Jeff Westergaard is Morningstar’s director of municipal analytics.

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