Municipal Bonds: What Are They and How Do They Work?

4 Looming Threats

Cities will have to choose between paying bonds and pensions.
People, mostly union and retired city workers, protest in front of the U.S. Courthouse where Detroit's bankruptcy eligibility trial began this morning October 23, 2013. By: Bill Pugliano/Getty Images

Definition: Municipal bonds are loans investors make to local governments. They are issued by cities, states, counties, or other local governments. For that reason, the interest they pay on the bonds is usually tax-free.

Municipal bonds are securities. That means the original owner may sell them to other investors on the secondary market. The price can change even though the interest rate never does.

The municipal bond market is $3.7 trillion. Sixty-percent of that is general obligation bonds. That means the municipality must repay them using current tax revenue. Nearly 40% of the municipal bond market is revenue bonds. The municipality repays those with proceeds from a specific source. These bond usually pay for revenue-generating projects. That includes toll highways, sports arenas, or city-sponsored developments. If the revenue sources dry up, the municipality doesn't have to pay. The third type of bonds are made on behalf of private groups with a public purpose. They include non-profit colleges and hospitals. The municipality just arranges the sale of the bonds. It's not liable for these debts if the private entity doesn't pay. (Source: "What Are Municipal Bonds?" Investor.gov.)

How They Work

Municipal bonds pay interest to investors, usually twice a year. Bond issuers repay the principal on the bond's maturity date.

That's one to three years for short-term bonds, and ten years or more for long-term bonds.

Municipal bonds work best for investors who need a tax-free revenue stream. Those are usually investors in a higher income-tax bracket. As a result, they have slightly lower interest rates than taxable bonds. You can buy them directly from a registered municipal bond seller.

You can also own them indirectly through a municipal bond fund.

In the past, very few cities defaulted. Municipal bonds are considered very low risk. Most individual municipal bond holders do not sell during the life of the bond. However, those that do find the price of the bond itself changes based on supply and demand in the open market.

4 Looming Threats

In 2014, former Federal Reserve Chairman Paul Volcker co-authored a three-year study with the boring title: "Final Report of the State Budget Crisis Task Force." Its findings were anything but boring. The team uncovered structural flaws in state and city financing that are worsening. That represents a future threat to all municipal bondholders. At its worst, it could trigger another financial crisis.

  1. Contributions to employee pension funds aren't enough to cover future guaranteed payouts to retirees. Cities have three poor choices. They must either raise taxes, reduce spending on other services,  or cut benefits. 
  2. The largest expenditure for state budgets is Medicaid.These health costs are rising, which could cut into state revenue-sharing with cities.   
  3. Cities and states are issuing bonds to cover current operating costs.
  4. They are selling off assets to pay operating expenses.

    As a result, they don't have the funds to invest in new infrastructure. That includes roads, bridges and buildings. It also includes education and other services. (Source: WSJ,  More Detroits Are on the Way , May 15, 2014)

    How Detroit's Bankruptcy Changed the Game for Municipal Bondholders

    On July 18, 2013, the city of Detroit filed for Chapter 9 bankruptcy on $18.5 billion in debt. It was the largest American city to take this desperate action. Detroit used the bankruptcy to default on its general obligation bonds. It said it no longer had the income to pay for the bonds. Creditors and insurers absorbed $7 billion in losses. They received between 14 and 75 cents on the dollar, depending on the type of bond. Pension funds agreed to a minimum 6.75% return. That was lower than what they had before, but still a high rate of return compared to other risk-free investments.

      That was in return for a 4.5 percent cut to monthly checks, an end to cost-of-living increases, and higher health care contributions.

    Detroit will spend $1.7 billion more on services. That means improving 911-response time. Detroit's average was 58 minutes, compared to the 11-minute national average.  Although the bankruptcy is a response to current debt,  Michigan's Governor Rick Snyder said it was 60 years in the making. It was exacerbated by the 2008 financial crisis. (Source: "Plan to Exit Bankruptcy Is Approved for Detroit," New York Times, November 7, 2014.)

    The ruling has a long-term impact on the U.S. economy by setting national precedents. The central issue at stake was who will pay the price. Will it be bondholders or city workers, whether currently employed or retired? Or will it be the residents? 

    Bondholders claim they were forced to pay more than their fair share. U.S. Bankruptcy Judge Steven Rhodes found that a city's obligations to pensions and to bonds are overuled by Federal bankruptcy laws. He still approved Detroit's plan, which forced bondholders to take larger cuts. That's because he wanted to be sure the plan was workable. Stockton, CA, also protected its taxpayers, employees, and retirees more than it did the bondholders.  Analysts warned a bankruptcy could drive up bond costs for cities statewide. (Source: "Detroit Bankruptcy Taught Muni Investors Painful Lessons," Bloomberg, September 6, 2014.  "Detroit Files for Bankruptcy," Detroit Free Press, July 19, 2013.  "Business Leaders Don't Expect Major Impact," Detroit News, July 18, 2013)

    How It Affects You

    Detroit's bankruptcy could eventually drive up the interest rates on new municipal bonds for all cities. That's if bond investors demand more return for the greater risk of municipal default.

    If this happened, the municipal bonds you own could drop in value because the newer bonds will pay more. However, most analysts don't think it will affect the $3.7 trillion municipal bond market. That's because most investors realize that most cities aren't in the same kind of financial straits as Detroit.

    The best way to protect yourself is to review city and states finances carefully. Pay attention to how they fund their operating expenses, including future pensions. You have to look at more than just the credit-worthiness of the bond itself.  

    Even if you don't invest in municipal bonds, keep an eye out for articles about any future city and state bankruptcies. The study warned that Detroit's problems are shared throughout the country. 

    What Are the Different Types of Bonds?