There are two common types of municipal bonds:
- General obligation bonds, also known as GOs, are issued by states, cities or counties. They are backed by the "full faith and credit" of the government entity issuing the bonds. This backing is only as strong as the entity's ability to levy taxes on its citizens, and in some cases charge user or assessment fees. The creditworthiness of GOs is based primarily on the economic vitality of the issuer's tax base. Highly-rated GOs tend to have a strong tax base.
- Revenue Bonds are backed solely by fees or other revenue generated or collected by a facility, such as tolls from a bridge or road, or leasing fees. The creditworthiness of revenue bonds tends to rest on a debt service coverage ratio—the relationship between revenue coming in and the cost of paying interest on the debt. Highly-rated revenue bonds usually have a debt service ratio of two or more (the revenue that comes in is twice as much as the cost of paying interest on the debt).
| Investor Warning: Unrated and low-rated muni bonds exist and are actively sold, and defaults occur. You should carefully weigh the significant risk of investing in highly speculative securities. While the absence of a credit rating is not, by itself, a determinant of low credit quality, investors in non-rated bonds should be prepared to make their own independent credit analysis of the bonds. If you are unable to do so, then ask yourself if losing your investment is worth the higher coupon rate these bonds may carry. |
Bond Insurance and Other Features
In addition to the general muni bond categories above, you can buy muni bonds with special features. For example, some muni bond issuers include a repayment protection feature—most often bond insurance—to insure their bonds at the time they are issued. A bond with insurance generally is able to come to market with a higher credit rating, making the bond more attractive to buyers, and at the same time lowering the issuing cost to the municipality. The protection can shield an investor from default risk to the extent that the protection provider promises to buy the bonds back or to take over payments of interest and principal if the issuer defaults.
Anticipation notes are short-term notes that are used by states and cities to meet a short-term financing need. They usually mature in less than a year and are generally issued at par and pay interest at maturity.
Other types of munis are floating-rate and variable-rate muni bonds. These bonds are extremely short-term investments that are issued with seven-day and 28-day put features, allowing the investor to "put" the bond back to the issuer or issuer agent. Generally, the bond's interest rate is recalculated on the "put" date based upon a percentage of prevailing rates for Treasury bills or other interest rates.
There are also municipal securities, including zero-coupon munis, that are structured to give investors a lump-sum payment at maturity that is equivalent to the principal invested, but have no regular interest payments. These bonds are issued at a deep discount to the maturity. This type of muni is often used to save for a specific event, such as college education, but because they do not pay interest until maturity, their prices can be volatile.
Like most other bonds, munis can have call provisions. Indeed, a high percentage of munis are callable, a feature that helps protect the issuer from interest rate risk and manage spending.
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