How Does a Municipal Bond Work?

Fundamentals: What is a Bond?

A municipal bond is similar to other bonds in that all bonds are loans under fixed terms. When a bond is purchased, the money is loaned directly to an authorized entity on very specific, legally-sanctioned terms. These terms include a promise to repay the money at a specific date and at the specified interest rate. Municipal bonds are bonds issued by cities or other local agencies, most often for the purpose of raising capital to finance a specific project. For example, your city government could declare that it is issuing 10 year bonds at 3 percent interest to raise money for building a new bridge or library.

What Makes a Municipal Bond Different from Other Bonds?

The standard difference between municipal bonds and other types of bonds (beyond who the issuing party is) is that the interest--the value gained by the bond--is exempt from federal and local taxation. However, these bonds are also typically issued at a lower-than-market standard interest rates, so they often perform roughly the same as similar Federal bonds in terms of net yield.

Degree of Risk

Municipal bonds are not as safe as those issued by the Federal Government. The US Treasury has never defaulted on its debts but some US cities have. Credit worthiness is therefore a real issue when considering municipal bonds, and should be investigated before such a bond is purchased. However, they are still a safe investment when compared to corporate bonds in general. A city may go into bankruptcy, but it does not simply cease to exist the way a bankrupt company might. Eventually, a city's creditors are repaid at least to some degree.