Towns use a variety of different ways to generate revenue to sustain the operations and functions that are necessary. Some rely on government grants to supplement revenue deficits to complete special projects, while others operate on lines of credit. Municipal bonds are another option for towns that find themselves with their backs up against the wall. Investors are turning towards this strategy to help out their home-town and turn a small profit in the process. If you're wondering why a town would issue a bond, here is what our research has revealed.
Why do towns issue municipal bonds?
Towns have operating expenses that continue daily. The revenues generated through payments for water, sewer, and garbage services, fees for building permits, taxes, licensing, and other fees help to sustain the day to day operations, but they fall short of covering everything. There is a never-ending storm of expenses associated with keeping a town maintained, operational, and safe for its residents. According to Zacks, many towns find themselves in the position of needing additional financing for meeting day to day expenses, but there are other reasons for generating extra funding.
Towns use funds generated from bonds to build new structures, to make repairs upon or improve existing buildings, to pay employee wages, to fund special projects, improve roadways, and other vital projects that are expensive to complete. The funds raised through the sale of bonds help cities to complete the projects that are necessary for the health and welfare of residents. These are the most common reasons why towns offer bonds.
What are municipal bonds?
Investor.gov explains what municipal bonds are and how they work. These bonds are issued by government entities including cities, states, counties, and others, for funding day to day commitments, to improve highways or sewer systems, to build schools or to finance capital projects. Investors who purchase municipal bonds lend money to the issuer in exchange for interest payments on the money loaned.
The benefits of investing in municipal bonds
Investors gain an advantage from purchasing municipal bonds because the investment is exempt from federal income tax. Some of these bonds have an exemption from state and local taxes if the investor is a legal resident of the state of issue. Municipal bonds can bring in a steady flow of income payments for investors in the form of interest on the bond for the duration of the life of the bond. The principal of the bond is paid when the bond matures.
What is the term length of municipal bonds?
The length of municipal bonds can vary. There are both short-term and long-term types with maturity dates that can extend from one to three years up to ten in most cases. Investing in municipal bonds is equal to investing in the quality of life for those who live within the community that benefits from the increase in funding of special improvement projects.
Different types of municipal bonds
There are two types of municipal bonds. These are General Obligation bonds and Revenue bonds. Investors purchase General obligation bonds in the faith of the reputation and credit of the issuer. Government entities or municipalities have the right to tax residents to fulfill bond payment obligations as a form of security. Revenue bonds are backed from the proceeds/revenues generated by the projects they fund. These are the riskiest investments of the two. If the revenue bond is listed as a "non-resource" type, bondholders may not file a claim on the underlying revenue source if the revenue stream from the project dries up. An example of a revenue bond is one that is issued to fund highways or a toll bridge with the tolls supporting the repayment of the bonds.
Facts about Municipal bonds
Before you invest in municipal bonds it's wise to familiarize yourself with the benefits and potential drawbacks. Money points out a few more details about municipal bonds that investors need to know. Both general obligation and revenue bonds are exempt from federal, state, and local taxes if you live in the place where they are issued. The investment duration may be advantageous because these bond issues offer various maturity dates. Some municipal bonds mature in one year while others may not reach full maturity for up to 38 years, with 10 years being the median duration. Most municipal bonds have a floating interest rate that can fluctuate with the prevailing market rate. Most municipal bonds are not fixed rates. These investments usually generate interest that is a point lower than US Treasury bonds, but there have been periods when municipal bonds have performed at a point or two higher.
What is a Zero Coupon Municipal bond?
There is one more type of municipal bond to discuss. The Zero Coupon type is a security that unlike the others, does not pay the bondholder interest payments through the duration of the life of the bond. Instead, all interest is paid at the time that the bond matures. The repayment with interest is made in one lump sum. Another difference with the Zero Coupon Municipal bond is that it is taxable. Investors may purchase this type in preparation for a significant expense such as college for children or the purchase of a new home. While the lack of tax exemption may at first seem like a downside of the Zero Coupon type, the interest rate on this type of bond is higher to offset taxation. From an investment strategy point of view, it's a wash.
Municipal bonds are beneficial for towns in need of additional funding for special projects or day to day operating expenses. Investors have several types from which to choose. They are commonly used for diversification of an investment portfolio and provide a reasonably low-risk investment. Some offer a steady stream of dependable income in the form of interest payments.
Written by Allen Lee
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