Fundamentals of Municipal Bonds



Just like corporations, federal, state, county and city governments have the ability to create debt that they use to pay for financing government projects such as construction of buildings, schools and roads. This debt is created by the issuance of a securities instruments called municipal bonds. There are two fundamental types of bonds - general obligation bonds that are backed and paid back (plus interest) with taxes, and revenue bonds, which are bonds issued by companies that operate under government auspices, such as utility companies. The bonds that these companies issue are paid back, again plus interest, with revenue derived from company revenue, usually sales of water or electricity.



Municipal bonds have two qualities that are of particular importance. First, they are backed by a government that has the ability to tax. Therefore, they are very unlikely to default on interest payments. In other words, they are very secure and unlikely to result in a loss of money for the holder. Second, the interest that they pay is exempt form federal income tax. This makes municipal bonds a fundamentally attractive investment vehicle for people who need the security of being able to receive interest payments while knowing there is little chance of default. In order for corporate bonds to equal the return on investment (ROI) of the municipal bonds, the corporate bon interest that was paid back minus taxes would have to match interest of the municipal bonds that have zero taxes.

There are a few fundamentals that one should be aware of when shopping for bonds. One of these is that investors should keep in mind is that the value of bonds changes inversely to the interest rate. If interest rates go up, bond values go down. That's because of "opportunity cost," the cost of holding a bond when a new bond could be purchased at the higher interest rate. But conversely, when interest rates go down, bond values go up. There have been periods of time in recent years when bonds actually performed better than stocks. The difference in interest rates creates the disparity in value of the two bonds.