Municipal bonds are issued by states, cities, counties, and other political subdivisions. They’re one of the main ways local governments borrow money to fund public projects. Many roads, schools, and parks are built with money raised through municipal bond offerings.
National politics often gets the most attention, but state and local decisions tend to shape day-to-day life more directly. Money raised in the municipal debt market affects local services, infrastructure, and overall quality of life.
Municipal bonds are typically structured like other bonds. Most pay semi-annual interest to investors seeking income. The 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 are a common type of municipal bond. They fund important projects for a city, state, or local area that don’t generate revenue. These are called non-self-supporting projects, meaning the project does not produce enough revenue to pay for itself.
Common examples include schools, roads, parks, and government buildings.
When a G.O. bond is issued, the municipal government borrows from investors and repays them over time. Because the project itself doesn’t generate revenue to cover debt service, the municipality must use taxes to repay the 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, support many local services, including school districts, police departments, park maintenance, and city libraries. If a municipality wants to fund a new non-self-supporting project, it can:
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. Full faith and credit bonds are generally not as safe as secured bonds, but a municipality’s taxing power is a major source of support. If a state or local government is short of funds needed to pay debt service on a G.O. bond, it can raise property taxes with voter approval.
Raising taxes isn’t always a complete solution, though. A municipality’s ability to repay G.O. bonds can also be affected by factors such as population trends, economic diversity, and existing municipal obligations.
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 one reason local leaders try to attract residents and businesses: more people and businesses generally means a larger tax base.
A single, dominant industry can also create risk. Detroit grew around the automobile industry. When the industry was strong, it supported jobs, wages, and a stable local economy.
By the time of the Great Recession of 2008, conditions had changed. The economy experienced the largest financial collapse since the Great Depression in the 1920s and 1930s. During economic downturns, consumers often delay purchases of durable goods like automobiles.
Auto sales plunged in 2008 and 2009, creating major problems for Detroit. With so much of the city tied to one industry, business closings and layoffs affected large portions of the population. Over the following years, many residents left to seek opportunities elsewhere, which further reduced the city’s tax base.
Municipalities can also be strained by large long-term obligations, such as pensions. Pensions are retirement plans that are generally only offered by government entities today. Under a pension plan, a retiree receives an ongoing benefit after retirement, typically for life. Many pension plans require at least 20 years of service to qualify. Once eligible, the benefit is often based on a percentage of the worker’s earnings (for example, 80% of the worker’s highest year of earnings) and is paid throughout retirement.
Pensions provide lifetime retirement income, but they can be costly for employers. The issuer is responsible for making payments regardless of its financial condition. Even if a municipality is under financial stress, pension payments still must be made. In Detroit’s case, pension payouts added to the strain during the late 2000s and early 2010s.
In summary, G.O. bonds fund state and local projects that don’t generate their own revenue. Repayment depends on the municipality’s ability to collect property (ad valorem) taxes. Factors that can strengthen a G.O. bond include a larger population and a more economically diverse tax base. Factors that can weaken it include population decline, reliance on a single industry, and heavy municipal obligations such as pensions.
Municipal revenue bonds fund projects that do generate revenue. If your city operates a facility that brings in money, it was likely built (at least in part) with funds raised through 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. These projects serve public needs while also generating operating revenue.
Before issuing a revenue bond, a municipality typically evaluates whether the project can realistically produce enough revenue to cover its costs. For example, suppose a city wants to build an aquarium that will charge admission. The aquarium will cost millions of dollars, and taxpayer money won’t be available for it. To estimate the project’s earning potential, municipalities hire independent consultants to prepare feasibility studies. These reports help determine whether the project or facility is likely to be profitable.
If the feasibility study forecasts a profitable aquarium, the city can move forward with construction. A self-supporting revenue bond is issued to the public, and the capital (money) raised is used to build the aquarium. Revenues earned from the aquarium are then used to pay off the bond over time. Most revenue bonds are considered self-supporting because they do not rely on taxes to repay borrowed funds.
Because revenue bonds are not paid off with taxpayer funds, they do not require voter approval to be issued. For the same reason, revenue bonds are not subject to debt limits either.
While most municipal securities are safe from default risk, defaults can still occur. It’s very rare for general obligation (G.O.) bonds to default, but revenue bonds face higher levels of default risk. In fact, revenue bonds default at 13 times the rate of G.O. bonds. Even so, revenue bond defaults are still fairly rare in the broader financial markets.
Liquidity risk is much more common than default risk. Many municipal bonds trade infrequently. In fact, many municipal bonds trade less than 50 times a year. For comparison, the average daily trading volume for Treasury securities in 2018 was $547 billion!
Liquidity risk is driven by the size and activity of the trading audience. If you try to sell a municipal bond issued by your city, you’re typically selling to a relatively narrow group of potential buyers - often other investors interested in that municipality or region. Municipal investors generally don’t trade with a national or global audience the way corporate and U.S. government security investors do.
This liquidity risk isn’t caused by the overall size of the municipal market. The municipal market is large - it was estimated at a size of $3.9 trillion in 2019. Instead, liquidity risk is often most noticeable in smaller municipalities.
For example, Wyoming had a population of 578,759 in 2019. Even if that sounds like a sizable number, only a fraction of residents participate in the municipal bond market. Of those who do, only some will be willing and able to trade at the moment an investor needs to sell. As a result, bonds from Wyoming - and especially from smaller cities or localities within Wyoming - can face significant liquidity risk. In general, the smaller the municipality, the higher the liquidity risk.
The last risk relates to yield. Municipal bonds offer tax-free income, but that benefit comes with a tradeoff: lower yields. Issuers can often offer lower yields because investors don’t pay taxes on the interest. While this isn’t the most severe risk, an investor in a low tax bracket should generally avoid municipal investments. Otherwise, they may face opportunity cost if other investments could provide a higher after-tax return.
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