Municipal bonds are issued by states, cities, counties, and political subdivisions. If you ever wondered how your city funds itself, municipal bonds play a crucial role. Your city and state roads, schools, and parks were most likely built with money borrowed through a municipal bond.
Although many of us pay attention to national politics, it’s what happens at our state and local levels that tends to influence our daily routines the most. Money raised in the municipal debt market has a direct impact on local resources and quality of life.
Municipal bonds are typically structured like normal bonds. Most pay semi-annual interest to investors seeking income. Capital (money) raised through offerings is used to hire employees, expand operations, and build new facilities.
In this chapter, we’ll focus on the two primary forms of municipal debt:
General obligation (G.O.) bonds
Revenue bonds
General obligation bonds
General obligation (G.O.) bonds are a common type of municipal bond. They support important projects for the city, state, or local area that don’t create revenue. G.O. bonds fund non-self-supporting projects, which include schools, roads, parks, and government buildings. A non-self-supporting project is one that does not make the required revenue to pay for itself.
When a G.O. bond is issued, the municipal government borrows from investors and pays them back over time. Because the bonds can’t be paid off with revenue obtained from the project, the municipality must use taxes to repay their borrowed funds. Specifically, G.O. bonds are paid off with property taxes.
Every year, property owners receive a tax bill from their local government based on how much and what type of property they own. Property taxes, also known as ad valorem taxes, are used to support many things, including school districts, police departments, park maintenance, and city libraries. If a municipality wants to fund a new non-self-supporting project, they raise money through a G.O. bond issuance, pay for the project, and use property taxes to pay back the borrowed funds over time.
G.O. bonds are typically not backed by a specific form of collateral. Instead, they are backed by the full faith, credit, and taxing power of the municipality. Normally, full faith and credit bonds are not as safe as secured bonds, but the taxing power of municipalities is a significant factor. If the state or local government is short of funds necessary to pay off a G.O. bond, they can raise property taxes with voter approval.
Raising taxes can’t always be a fix for a lack of money, though. Many other components, like population growth, economic diversity, and municipal obligations can affect a municipal issuer’s ability to pay off its G.O. bonds. For example, the city of Detroit filed for bankruptcy in 2013, which is still the largest municipal bankruptcy filing in US history. Contributing factors included a declining population, a single dominant industry (auto industry), and significant pension obligations.
When a municipality’s population declines, the local government loses taxpayers. This is why local politicians encourage people and businesses to move to their city. The more people that live in the city, the more taxes the government can assess.
A single, dominant industry within a municipality can be a recipe for disaster. In Detroit, the entire city grew around the automobile industry. When the industry took off, it created a booming city full of opportunities. Workers knew their jobs were stable, made good wages, and were able to live comfortably.
Fast forward to the Great Recession of 2008, things were different. The economy experienced the largest financial collapse since the Great Depression in the 1920s and 1930s. When the economy is rough, people generally avoid buying durable goods like automobiles.
Auto sales plunged in 2008 and 2009, which created big problems for Detroit. With the entire city built around the industry, there were numerous business closings and layoffs that affected significant portions of the population. These problems contributed to a dwindling tax base over the next several years as many people left Detroit to seek better opportunities outside the city.
Municipalities also face challenges when they have significant payout obligations, like pensions. Pensions are retirement plans which are generally only offered by government entities today. If your job provided a retirement pension, you would be paid an ongoing benefit until death (after retirement). Most employers require at least 20 years of service to be eligible for a pension. When the pension requirements are met, employers typically match their worker’s average earnings at a specific percentage (for example, paying 80% of the worker’s highest year of earnings) throughout their retirement (until death).
Pensions are great for workers as they provide retirement income for life, but they are burdens for employers. Organizations offering pensions know they are on the hook for making a lifetime of payments, regardless of their financial situation. Even if a municipality is experiencing significant financial problems, payments still must be made to pension retirees. When Detroit was financially challenged between the late 2000s / early 2010s, pension payouts strained them further.
In summary, G.O. bonds provide funding to state and local governments for all of the important projects that don’t make their own revenue. The success of a G.O. bond hinges on the municipality’s ability to pay back borrowed funds, which are collected through property taxes. For example, the more diverse the municipality’s economy and the larger the population, the higher quality of the G.O. bond. Economic diversity, which results in many different industries being prominent in the city or state, helps avoid issues that Detroit faced in the late 2000s and early 2010s. A larger population means more people pay property taxes. On the other hand, municipal obligations like pensions may hinder their ability to make required payments.
Revenue bonds
You probably guessed it, but municipal revenue bonds support projects that make revenue. If your city operates anything that makes them money, it was most likely built with funds raised by a revenue bond issue.
Toll roads, airports, stadiums, city zoos, convention centers, and water treatment plants are all examples of ventures supported by revenue bonds. Each is a part of a city’s fabric, but also obtains revenue from its operations.
If a municipality wants to fund a profitable venture with a revenue bond, it first must ensure its money-making potential. Assume your city wants to build an aquarium, which they hope people will visit and pay to get into. The aquarium will cost millions of dollars and taxpayer money won’t be available for it. To determine the earning potential for the venture, municipalities hire independent consultants to prepare feasibility studies. These are reports created by independent consultants to help the municipality determine if the project or facility will be profitable.
If the feasibility study forecasts a profitable aquarium, the city will begin planning its construction. A self-supporting revenue bond will be issued to the public, and the capital (money) raised will be used to build it. Revenues earned from the aquarium will be used to pay off the bond over time. Most revenue bonds are considered self-supporting because they do not rely on taxes to pay back borrowed funds.
Revenue bonds are not paid off with taxpayer funds, so they do not require voter approval to be issued. For the same reason, revenue bonds are not subject to debt limits either.
Risks
While most municipal securities are safe from default risk, this isn’t always the case. While it’s very rare for general obligation (G.O.) bonds to default, revenue bonds face higher levels of default risk. In fact, revenue bonds default at 13 times the rate of G.O. bonds. However, revenue bond defaults are still fairly rare in the grand scheme of finance.
The trading audience is what drives liquidity risk. If you try to sell a municipal bond from your city, who do you think you’re attempting to sell the bond to? Other residents of your municipality in most cases. Municipal investors don’t trade securities with a national or global audience like corporate and US Government security investors do. The overall size of the market is not what drives the liquidity risk of municipal bonds. The municipal market is huge - it was estimated at a size of $3.9 trillion in 2019.
Liquidity risk is especially apparent for smaller municipalities. For example, Wyoming had a population of 578,759 in 2019. While this sounds like a decent amount of people, how many of them trade municipal bonds? And for those that do, how many would be willing to trade when an investor needs to liquidate? Bonds from Wyoming, or especially cities or localities in Wyoming are subject to significant levels of liquidity risk. The smaller the municipality, the higher the liquidity risk.
The last risk to discuss relates to yield. Municipal bonds have the benefit of tax-free income, but this benefit doesn’t exist for free. The drawback of tax-free income is low yields. Issuers know they can offer their bonds at low yields because of the lack of taxes investors pay on the interest. While it’s not the most devastating risk, an investor at a low tax bracket should avoid municipal investments. Otherwise, they’re experiencing opportunity cost when other investments could pay them a higher after-tax return.
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