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What are municipal bonds?

Municipal bonds are issued by:

  • States
  • Cities
  • Counties
  • Other government entities

These bonds are used to raise money for:

  • Building schools
  • Building highways
  • Building sewers
  • Basically anything related to what local cities, counties or states need funding for

There are two main types of municipal bonds:

  • Revenue bonds
  • General obligation bonds
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16.1 Revenue bonds

  1. Investor buys a revenue bond from a government entity (municipal)
  2. The municipal uses this money to fund the project
  3. The investor is paid interest and principal at maturity from the revenue sources from the project

Revenue bonds are backed by the project the funding is raised for. Think about highway tolls or lease fees. This is making municipal bonds very diverse but should be treated with caution. You need to know exactly how the bonds are backed by who and what revenue stream. This is very important because the investor buying municipal bonds has no claims if the revenue stream dries up or if the issuer does not make payments anymore. This is called “non-recourse”.

Sometimes municipal borrowers issue bonds on behalf of private entities. As municipal bonds are mostly used to fund new projects, it’s very important to check all the financial data of the issuer and other related (private) parties. Projects may fail due to lack of money management or a bad market. As the investor has no claim if payments are stopped, it’s your responsibility to check if the project has potential. While it does not say everything about a bond or company, you can always check the credibility rating I talked about before.

Municipal bonds are not taxable on state, local (if the bond is from the state you live in) and federal level in most cases.

16.2 General obligation bonds

  1. Investor buys a revenue bond from a government entity (municipal)
  2. The municipal uses this money to fund the project
  3. The investor is paid interest and principal at maturity from tax income issued by the municipal

General obligation bonds are not backed by any revenue stream. Most GOB’s are backed by taxes. For example, the government entity can raise taxes or use taxes to pay the bond holders. Other than that there is no credibility other than having faith in the government entity.  

Type Maturity Interest rate Collateral
Revenue bonds Variable Variable Variable (but can’t be claimed)
General obligation bonds Variable Variable Mostly taxes

16.3 Pro and cons of municipal bonds

Pro’s Cons
Not taxable in most cases Callable
Less risky vs stocks Credibility risks 
High liquidity Risk of default
  Interest rate risk
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