How Are Municipal Bonds Repaid?

Terms of repayment are created in the indenture.

Municipal bonds are obligations of state and local governments and other special districts created under state auspices. Municipal bonds secure their obligations either through the full faith and taxing power of the municipality (general obligation bonds) or through a specific revenue stream (revenue bonds) or a combination of both cash streams. Municipal bonds pay interest semiannually and repay principal according to a maturity schedule. Bond repayment follows directly from the terms of the legal bond indenture.

Bond Covenants and Indentures Determine Rules of Repayment

Every municipal bond has indentures and covenants.

Every publicly traded bond issue is negotiated by the underwriters and the issuer to provide a detailed map of the bond's payment structure. These details are embedded in bond covenants and indentures. The issuer affirms the right to collect revenues and expects to have revenues sufficient to pay all bondholder's principal and interest, or the issuer will be in default of the covenant.

The Trustee of a Bond Issue Represents Issuer and Borrower

Trustees and paying agents have important fiduciary responsibilities.

At the time of the bond closing, a trustee is appointed with the authority to enforce the bond agreement. Usually the bond trustee function is fulfilled by the trust department of a large bank. The trustee draws monies from corporate funds in advance of the payment date and makes payment to the paying agent. The paying agent holds funds while waiting for all interest payments to be claimed by bondholders. The repayment process is done automatically and electronically today.

Sources of Payment

Bonds are secured by many revenue streams.

Bond covenants detail the source of payments for municipal projects. General obligation bonds are the most common and represent the full faith and taxing power of the issuer to pay off the debt. G.O. bonds, as they are commonly called, are considered the strongest of all bonds because they may call on any revenue source in order to make bond payments.

Municipal Revenue Bonds

Bond payments may come from one or more revenue sources.

General obligation bonds affect the credit of the entire municipality because all municipal revenue sources could conceivably be drawn down in order to make interest payments. Municipal revenue bonds rely on one or more specific taxes to pay all debt service. Examples of revenue bond tax sources are dedicated state income taxes, bridge and tunnel tolls, tobacco taxes or other user taxes.

The Margin of Error to Pay Bonds

Bond documents offer a cash flow projection of available tax flows. Revenue bond issues are required to surpass the minimum amount of cash for debt service. They do so by charging sufficient fees so that interest and principal repayments each year are exceeded by a factor of 10 to 20 percent. This added pledge of security ensures the safety of the bond, allowing for a higher credit rating.

Resources

• Municipal Securities Rulemaking Board