Fixed Income Types: Municipal Bonds

Municipal Bonds Simplified: Tax-Free Investing and How It Works

Let's talk about municipal bonds - they're like loans, but instead of banks, it's your local government asking for help. They use the money for things like fixing roads, building schools, and making the city better.

What Are Municipal Bonds?

Municipal bonds are like IOUs from your city. You lend them money, and in return, they promise to pay you back with a little extra (interest). It's a win-win - you help your city, and they thank you for it!

Types of Municipal Bonds

General Obligation (GO) Bonds

These are super safe. The city promises to pay you back using its taxing power. Imagine it's like saying, "We'll use a bit of everyone's taxes to make sure we pay our debts."

Example: Your city wants to build a new library, so they ask people to lend them money through GO bonds. If they don't pay back, they'll use property taxes to cover it.

Revenue Bonds

These bonds are paid back from money made by specific projects, like toll roads or airports. It's like saying, "We'll use the money we make from this cool project to pay you back."

Example: If your city builds a new airport and needs money, they ask people to lend them cash through revenue bonds. The money they make from the airport covers the loan.

Special Tax Bonds

These are paid back using specific taxes, like sales taxes. It's like saying, "We'll use a slice of the money from these special taxes to pay you back."

Example: Your city wants to build a convention center, so they ask people to lend them money through special tax bonds. The money from special taxes in that area helps repay the loan.

Investing Tricks: Municipal Derivative Securities

Municipal Swaps

Think of these as deals to make things stable. If the city borrowed money with changing interest rates, they might swap with someone to make the payments more predictable.

Example: Your city borrows money with changing interest rates. They make a deal (swap) with someone to keep the payments steady, so they're not surprised by big bills.

Municipal Options

Options give investors choices. If you have municipal bonds and want to be safe, you might buy an option. It's like saying, "I want the choice to sell these bonds later at a set price."

Example: You have municipal bonds, but you're worried the value might drop. You buy an option, which gives you the choice to sell them at a fixed price later if things go south.

Municipal Inverse Floaters

These are a bit different. It's like having a loan with an interest rate that does the opposite of a regular loan. If one part goes up, the other goes down.

Example: Your city takes out two loans - one with a fixed interest rate and the other with an interest rate that goes down when the market rate goes up. This way, they save money if interest rates rise.

Tax Risks

Legislative and Regulatory Risk

Changes in tax laws can affect your bond's tax-free status. If laws change, the interest you earn might not be tax-free anymore, and your bond's value could drop.

Alternative Minimum Tax (AMT) Risk

Some bonds might have extra taxes. If you have these bonds, you might need to pay more taxes than usual. It's like saying, "Watch out, some bonds have extra tax rules."

Yield Spreads in the Municipal Market

Yield spreads are like the price tags in a store. They show the difference in value between municipal bonds and other similar investments. Different things, like how safe the investment is or how much people want it, can change the price.

Primary and Secondary Markets

Primary Market

This is where cities ask people to lend them money by selling new bonds. Big investors like banks usually buy here.

Secondary Market

This is where people who already have bonds can sell them to others. It's like a second-hand store for bonds.

How You Can Join In

Individual Investors

You can buy new bonds directly from your brokerage account or from your financial advisor. If you already have bonds, you can also sell or buy more in the second-hand market.

Institutional Investors

Big players like mutual funds and insurance companies can buy bonds directly from the city or from others in the second-hand market. It's like saying, "Anyone can play in the bond market."

Conclusion

Municipal bonds are a way for you to help your city and make some money. Knowing about the different types, tricks with derivatives, tax risks, and how the markets work helps you make smart choices and be part of your community's growth.

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.