Municipal bonds are issued by states, cities, counties, and other political subdivisions. If you’ve ever wondered how your city funds itself, municipal bonds are a big part of the answer. Many local roads, schools, and parks are built with money borrowed through municipal bond offerings.
Even though national politics gets a lot of attention, state and local decisions often 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 support important projects for a city, state, or local area that don’t generate 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 generate enough revenue to pay for itself.
When a G.O. bond is issued, the municipal government borrows from investors and repays them over time. Because the project itself doesn’t produce revenue to cover debt service, the municipality must use taxes to repay the borrowed funds. Specifically, G.O. bonds are typically repaid with property taxes.
Every year, property owners receive a tax bill from their local government based on the value and type of property they own. Property taxes, also called 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 specific collateral. Instead, they’re backed by the full faith, credit, and taxing power of the municipality. Full faith and credit bonds are generally less secure than collateralized (secured) bonds, but a municipality’s taxing power is an important source of support. If a state or local government is short of funds needed to pay debt service on a G.O. bond, it may be able to raise property taxes with voter approval.
Even so, raising taxes isn’t always a complete solution. A municipality’s ability to repay G.O. bonds can be affected by factors such as:
For example, the city of Detroit filed for bankruptcy in 2013, which remains the largest municipal bankruptcy filing in US history. Contributing factors included a declining population, reliance on a single dominant industry (the auto industry), and significant pension obligations.
When a municipality’s population declines, the local government loses taxpayers. That’s why local leaders often try to attract residents and businesses: more people generally means a larger tax base and more property tax revenue.
A single dominant industry can also create risk. Detroit grew around the automobile industry. When the industry expanded, it supported strong employment, stable wages, and a growing city.
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. Because so much of the local economy depended on the auto industry, business closures and layoffs affected large portions of the population. Over the following years, many residents left Detroit to find opportunities elsewhere, which further reduced the city’s tax base.
Municipalities can also face pressure from large long-term obligations, such as pensions. Pensions are retirement plans that are generally offered by government entities today. Under a traditional pension, a retiree receives an ongoing benefit for life after meeting service requirements (often 20 years or more). Benefits are commonly based on a percentage of earnings (for example, 80% of the worker’s highest year of earnings) and continue until death.
Pensions provide lifetime retirement income for workers, 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 to retirees. When Detroit faced financial challenges in the late 2000s and early 2010s, pension payouts added to the strain.
In summary, G.O. bonds fund state and local projects that don’t generate their own revenue. Their credit quality depends on the municipality’s ability to repay borrowed funds using property taxes. Factors that tend to support stronger G.O. bonds include a larger population (more taxpayers) and a more diverse economy (less reliance on one industry). On the other hand, large municipal obligations (such as pensions) can make repayment more difficult.
Municipal revenue bonds support projects that 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, but they also generate operating revenue.
If a municipality wants to fund a revenue-producing venture, it first needs to evaluate whether the project can realistically generate enough money to cover its costs. Suppose your city wants to build an aquarium that visitors will pay to enter. 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 the municipality 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 planning and 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 repaid with taxpayer funds, they do not require voter approval to be issued. For the same reason, revenue bonds are not subject to debt limits.
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 have higher default risk. In fact, revenue bonds default at 13 times the rate of G.O. bonds. Even so, revenue bond defaults are still relatively 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 fewer than 50 times per 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, the likely buyers are often other investors familiar with (or located in) that municipality. Municipal securities generally don’t trade with the same national or global investor base as corporate bonds or US government securities. This isn’t because the municipal market is small - it’s large, estimated at a size of $3.9 trillion in 2019 - but because many individual issues have limited trading interest.
Liquidity risk is especially noticeable for smaller municipalities. For example, Wyoming had a population of 578,759 in 2019. Even if that sounds sizable, only a fraction of residents participate in the municipal bond market, and an even smaller fraction may be active buyers at the moment an investor needs to sell. Bonds issued by Wyoming - and especially by 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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