What is a bond?
A bond is just an organization's IOU; i.e., a promise to repay a
sum of money at a certain interest rate and over a certain
period of time. In other words, a bond is a debt instrument.
Other common terms for these debt instruments are notes and
debentures. Most bonds pay a fixed rate of interest (variable
rate bonds are slowly coming into more use though) for a fixed
period of time.
Why do organizations issue bonds? Let's say a corporation needs
to build a new office building, or needs to purchase
manufacturing equipment, or needs to purchase aircraft. Or maybe
a city government needs to construct a new school, repair
streets, or renovate the sewers. Whatever the need, a large sum
of money will be needed to get the job done.
What are municipal bonds? Municipal bonds are issued by cities,
states, and other local agencies and may or may not be as safe
as corporate bonds. Some municipal bonds are backed by the
taxing authority of the state or town, while others rely on
earning income to pay the bond interest and principal. Municipal
bonds are not taxable by the federal government (some might be
subject to AMT) and so don't have to pay as much interest as
equivalent corporate bonds.
Municipal bonds (also known as "munis") are attractive to many
investors because the interest income is exempt from federal
income tax, and in many cases, state and local taxes as well. In
addition, munis often represent investments in state and local
government projects that have an impact on our daily lives,
including schools, highways, hospitals, housing, sewer systems
and other important public projects.
Two Varieties of Municipal Bonds Municipal bonds come in two
varieties: general obligation bonds and revenue bonds. General
obligation bonds, issued to raise immediate capital to cover
expenses, are supported by the taxing power of the issuer.
Revenue bonds, which are issued to fund infrastructure projects,
are supported by the income generated by those projects. Both
types of bonds are tax exempt and particularly attractive to
risk-averse investors due to the high likelihood that the
issuers will repay their debts.
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