Municipal bonds are issued by states, cities, towns or counties, or their agencies. Congress authorizes these entities to issue debt whose interest payment is tax-exempt for those investing in the bonds. Bonds are typically backed by taxing power or by specific revenues from such sources as water and sewer authorities. Through the underwriting process, debt is sold to the public via the capital markets, such as major brokerage firms and regional broker/dealers. Bonds are then resold to investors who favor the relative historical safety of principal and tax-exempt interest payments. Municipal bonds are also purchased by institutional investors, such as banks and insurance companies, who also benefit from the bonds' tax-exempt status.
Municipal bond types include: General
Obligation, which are backed by taxing powers; Revenue,
which are backed by specific revenues, such as water and
sewer; and Pre-Refunded, or bonds whose future principal
and interest payments are being paid by established escrow
accounts.
Bond features include:
- Coupon considerations
(premium and discount)-Bonds with coupons that feature
rates higher than prevailing interest rates trade at a
premium dollar price. Coupons with rates lower than prevailing
rates trade at a discount. Underwriters
will structure coupons to appeal to current market conditions.
- Redemption features (callable bonds)-The majority of bonds allow the issuer the option to call the bond after 10 years. Many revenue bonds also have calamity calls, which come into play if the structure that backs the revenue is destroyed (for example, the destruction via force of nature of a toll bridge).
- Maturity schedules-Municipal issues generally
offer principal amounts amortized out over a number of
years.
- Rating and credit enhancements-Bonds are rated by such agencies as Moodys, Standard & Poors and Fitch. The majority of new municipal bond issuers also buy bond insurance as a form of credit enhancement and to gain the highest rating, AAA, if the issuer does not already have that rating. Ratings indicate the grade of each issue. While the grading companies use similar but different letter applications (such as AAA, Ba1, Caa, D, etc.), their ratings all range from the highest grade to the lowest as follows: Prime, or Maximum Safety, High Grade Quality, Upper Medium Grade, Lower Medium Grade, Non Investment Grade, Speculative, Highly Speculative, Substantial Risk, In Poor Standing, May Be in Default and Default.
