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What in the world
is a municipal bond?
By Ed
Roche • Bankrate.com
I am a municipal bond credit analyst. I'm the guy
you meet at parties to whom you don't know how to respond when he
tells you what he does for a living. I am well aware that the mere
mention of my polysyllabic, yawn-inducing profession opens a conversational
pothole. Tossing out all those words breaks the unwritten rules
of chit-chat, trips up the whole conversational flow. But, since
you've clicked on "What in the world is a municipal bond?" I'm going
to assume you're dying to hear about what I do. This is my chance
to answer those never-asked party questions.
Municipal bonds are essentially IOUs. Cities, school
districts, states and other public entities (aka municipalities)
borrow money from investors. In exchange for your cash, they give
you municipal bonds, which promise to pay a certain rate of interest
over the life of the bond plus the original amount borrowed when
the bond matures.
Suppose you buy a $10,000 10-year bond with a coupon
(interest payment) of 7%. If you hold it to term, you'll have collected
$7,000 in interest payments by the time your $10,000 is returned
after 10 years. It's that simple. No fretting the ups and downs
of the Nasdaq -- you always know what you're going to get right
up front.
Since the rate of return and the semiannual interest
paid to investors is fixed for the life of the bond, as is the face
value paid upon maturity, municipal bonds fall into the family of
fixed-income securities. Fixed-income also includes U.S. government-issued
Treasury Bonds, corporate bonds, and other forms of securitized
debt, such as student loans and mortgages.
If we were at that party, you'd have bolted for the
bathroom by now. But, since you pointed and clicked at me, you must
be wildly interested and will read on.
Bondholders want to make sure they'll get that return
on their investment and the face value at the end of the term, but
who has the time (not to mention the inclination) to check out the
financial situation of the Oshkosh School District in Winnebago
County, Wisconsin? Why, I do. Credit analysts look at the "underlying
credit fundamentals" (I have never once said that outside the office)
in order to gauge the risks for investors in lending money to municipalities.
When you apply for a mortgage, the bank checks you
out, taking a look at your credit history, employment history, rent
payment history, etc. They need to make sure you can pay them back
the money you're about to borrow (plus interest, of course). The
same thing has to be done when municipalities want to borrow money,
whether it's for a water system or a new baseball stadium.
Key credit characteristics include:
-
The security -- what backs the bonds.
A water revenue bond is secured by the revenues of Anytown,
U.S.A.'s water system. When customers pay their water bill,
some of that money is used to repay bondholders.
-
The project being financed -- an
airport, a new high school, a bridge
-
Anytown's financial position and socio-economic
profile -- how many rich/poor people, the employment rate,
the dominant industry, etc.
The interest on munis is exempt from both federal
and state taxes (for residents of the state in which the bond is
issued). So, New York City residents, for example, can get triple
tax savings by buying NYC munis, since they pay no federal, state
or local income tax on them. Investors trying to minimize their
tax hit will find municipal debt attractive, not to mention safe.
Municipalities almost never go out of business and they don't move.
They tend to have large capital needs that require them to borrow
money on a regular basis and if they expect to borrow in the future,
they must repay their bondholders.
The price you pay for safety is a relatively low return.
Municipal bonds and Amazon.com are about as far apart on the risk
and reward scale as you are going to get. In the end, though, investors
should not be thinking stocks OR bonds. After all, they complement
each other well. Safe, tax-free income helps ease the pain of the
latest dotcom's nosedive and when biotech surges, you don't feel
so bad about holding a muni with a 5.75 percent return. The investment-party
wallflower -- I know how it feels.
So, what do you do?
-- Posted: Feb. 23, 2000 |
