Two parts – general obligations and revenue bonds – are the ones in which municipal bonds can usually be categorized. General obligation, or GO bonds, are guaranteed by the issuing municipality’s general revenue, including tax. In contrast, revenue bonds are secured by specific sources of revenue, such as toll road revenue, hospital revenue, or the education system.
Almost two-thirds of all outstanding municipals are of this investment class, but revenue bonds are less attention-seeking than their more popular general bond equivalent. The quality of credit varies with revenue bonds. Still, it can be an excellent opportunity for municipal investors to diversify portfolios or add higher return investments if they are ready to take greater risks. Municipal bonds are widely offered by local and state administrations, including both GO bonds and revenue bonds, to;
- Assist pay public projects and municipal operations such as new schools or city sewer reparations.
- They normally have no federal tax and can be free from tax on state income if the bond issuer is situated in the investor’s home country.
This is why municipals are typically attractive to income-oriented investors who want to cut tax bills on income.
Types of Municipals
A typical error among investors is to put in the same category all income bonds. Due to the scale and complexity of the revenue bond market, intelligent investors can benefit by picking and concentrating part of their municipal bond portfolio on the appropriate form of revenue bonds for their purposes. Most income bonds are supported by a “net” or gross commitment to company income. A rough commitment is a stronger commitment as a commitment to revenue before operations or other costs. A net commitment is a commitment to income after the business pays for operations and other costs. Below are the several categories of income bonds and the various business risks that can be faced.
Water/Electric Related Revenue Municipal Bonds
To fund the development and upgrading of sanitation or water utilities, Water and wastewater bonds are issued. Debt service revenue is obtained from several rates and levies, most frequently based on use and relationships. For example, power utilities acquire or generate electricity and supply it to their components. In some utility districts, equity or taxable debts are owned or operated publicly. However, a municipality or government agency may issue tax-free debt to owned and/or operated utilities.
Income bonds for water and wastewater are regarded as “essential services” and are considered more conservative municipal bonds. In Moody’s Investors Service, debt service coverage for sewer and water services is on average rated ‘healthy in all kinds of systems’ by placing issuers in a more sound position to cover bond payments. Bonds between governmental authority and electricity are often more intricate, but “vital services” can be regarded. They have tended to be subject to more public and regulatory scrutiny because electricity is one of the main sources of CO2 emissions. Debates about the environmental effects of CO2 emissions and technological progress in this field are unique challenges.
Special Tax Revenue Municipal Bonds
A special bond is a bond, which is reimbursed by charging a tax on a given activity or item. For example, the sale of alcohol or tobacco to finance a new cancer research facility may be subject to a special tax. The credit quality of these bonds depends on taxation, the social or economic trends which affect the use of such activity or asset, and legislative protection against the provision of public funds. For example, the rise in the use of tobacco products is of relevance if a specific tax is paid on the sale of tobacco. Depending on the coverage and legal protection, such bonds can be highly robust. As this may affect the credit rating of the special income tax bond, investors should pay special consideration to the loan rating of the sponsoring undertaking.
Transport Related Revenue Municipal Bonds
To fund public transport projects, such as buses, subway systems, toll highways, or airport systems, transport revenue bonds are issued. The transportation system’s income can repay the bonds. However, taxes collected in the field related to the system service or any other promise are paid back for some transport income bonds. At its simplest level, the quality of the credit of a transport revenue bond depends on the service provided by its issuer to the public and the credit commitment. The credit quality of a transport income bond may vary considerably, and, in general, more important systems are more flexible when it is necessary to increase rates. Transport income bonds supported by a wider commitment also tend to obtain higher credit ratings on average compared to only farebox income. As transport systems and infrastructure are crucial for a municipality, it comes as a challenge to the issuers of these bonds to get people to invest heavily in these bonds to collect money to fund such infrastructure needs. The issuers need to offer incentives to attract more investors. These bond loans will require a higher rate and maybe a nice supplement to general bond offerings for a strongly dependent municipality on public transit.
Most municipal bonds pay a fixed rate of interest so, if the rate of interest increases in the market, the demand for the bonds decreases, leading to a decrease in the bond price. On the other hand, if the interest rate decreases, the price of the bond increases because receipts on the bond are fixed, and a comparatively higher return is to be generated. Furthermore, longer-term obligations are more likely to change interest rates than a short maturity bond that causes even greater changes in the holder’s income in the municipal bond. The bulk of municipal bonds are also illiquid. Instead of selling other securities, an investor requiring immediate cash must go for municipals. Many municipal bonds feature telephone calls that allow the issuer to pay the bond before the expiration date.
Overall, municipal bonds offer a great way to invest in something offering good returns, medium risk, tax benefits in some cases and allows the investor to be a part of a community. Plus, it’s good for diversification purposes too.