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Individual Bonds: Municipal

Municipal bonds are debt obligations issued by public entities that use the loans to fund public projects such as the construction of schools, hospitals, and highways.

Reasons to consider municipal bonds

  • Interest income generally federally tax exempt
  • Low level of default risk relative to other bond types

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All municipal bonds fall into one of two categories—general obligation or revenue bonds—based on how the interest and principal repayment will be funded. Within each category, municipal bonds can be structured a number of different ways, each with different benefits and tax treatment.

General obligation bonds (GOs)
General obligation bonds represent a promise by the issuer to levy enough taxes as necessary to make full and timely payments to investors.

Revenue bonds
Principal and interest payments for revenue bonds are secured by revenues generated by the particular project being financed. In some cases revenue bonds can be backed by sales taxes, fuel taxes, or hotel occupancy taxes.

The issuers of revenue bonds are generally:

  • Non-profit organizations (501(c)( 3)).
  • Private-sector corporations (such as hospitals).
  • Entities that provide a public service (such as power utilities, public transportation authorities).

Insured bonds
Some municipal bonds are insured by policies written by commercial insurance companies. The insurance policy is intended to provide for the insurer to pay principal and interest payments to bondholders in the event the issuer defaults. Investors should take into account the creditworthiness of both the insurer and the issuer when considering insured bonds.

Taxable municipal bonds
The interest on some municipal bonds is taxable because the federal government will not subsidize the financing of activities that do not provide significant benefit to the public. Bonds issued to finance things like stadiums, replenishment of a municipality’s underfunded pension plan, or investor-led housing are a few examples of issues that would not qualify for federal tax exemption. Build America Bonds (BABs) are a recent category of taxable municipal bonds, introduced in the wake of the 2008 financial crisis. The advantage for issuers is that they receive a 35% federal rebate on interest costs for these bonds. BABs only subsidize an issuer’s borrowing cost. There is no implied backing from the federal government.

Zero-coupon bonds
Zero-coupon municipal bonds are issued at an original issue discount, with the full value, including accrued interest, paid at maturity. Interest income may be reportable annually, even though no annual payments are made. Market prices of zero-coupon bonds tend to be more volatile than bonds that pay interest regularly.

Original-issue discount bonds
These are municipal bonds issued at a price below face value (par) which qualify for special treatment under federal tax law. The difference between the issue price and the face value is treated as tax-exempt income rather than as capital gains if the bonds are held to maturity.

Pre-refunded bonds
Pre-refunded bonds result from the advance refunding of bonds that are not currently redeemable. Once issued, the proceeds are placed in an escrow account set up to generate enough cash flow to pay interest and principal up to the first call date. The goal is typically to provide present-value savings to the issuer, but in some cases can be used to change the indenture on the bonds. The escrow account is most often funded with U.S. Treasuries (although other instruments are sometimes used), in which case the pre-refunded bonds are considered relatively safe.

Escrowed-to-maturity (ETM) bonds
Bonds are "escrowed to maturity" when the proceeds of a refunding issue are deposited in an escrow account for investment in an amount sufficient to pay the principal and interest on the issue being refunded. In some cases, though, an issuer may expressly reserve its right to exercise an early call of bonds that have been escrowed to maturity. The escrow account is most often funded with U.S. Treasuries (although other instruments are sometimes used), in which case the escrowed bonds are considered relatively safe.

Housing bonds
Housing bonds are securities backed by mortgages and mortgage loan repayments. Although not reflected as part of a traditional "call schedule," these bonds can be called at any time from the prepayment of principal on the underlying mortgages, and therefore display as callable and subject to extraordinary redemption (ER) provisions.

Municipal notes
Municipal notes are short-term debt obligations that usually mature within a year or less, but may mature within two or three years, depending on the source of the redemption. Municipalities issue notes to generate stable cash flow while they wait for other expected revenues. The types of municipal notes depend on the source of future cash flow, such as Tax Anticipation Notes (TANs), Revenue Anticipation Notes (RANs), and Bond Anticipation Notes (BANs).

Conduit bonds
These are revenue bonds issued by state agencies called “conduit issuers” that are third-party entities that act on behalf of the actual borrowers, typically private nonprofit (501(c)(3)) entities. Conduit bonds may be issued for projects such as nonprofit hospitals, housing developments, transportation hubs, student loan programs, and public works projects. The third-party, conduit borrower—not the issuing agency—is responsible for interest payments and principal repayments. The issuing agency generally is not obligated to use any other source to repay the bonds if the conduit borrower fails to make loan repayments. So, unless the official statements indicate otherwise, investors in conduit bonds should not view the issuing governmental agency as a guarantor on conduit bonds.

Next steps

Find municipal bonds. Choose from 40,000 new issue and secondary market bonds & CDs, and approximately 60,000 total offerings with our Depth of Book.

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Additional resources

Municipal Securities Rulemaking Board (MSRB)
Find the official financial statements and notices of material events for a specific bond. Visit the MSRB site and enter the CUSIP number or issuer's name.

Municipal Bonds: Understanding Credit Risk (PDF)
Learn more about assessing credit risks when purchasing municipal bonds in this SEC investor bulletin.

Preliminary official statements
Get information on the health and nature of a new issue’s revenue stream (taxpayers/customers), the operational capabilities or efficiency of the entity, and the competency of financial management at the organization over time.

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accrued interest

the interest received from a security's last coupon interest payment date up to the current date or date of valuation; when calculating accrued interest for a bond traded in the secondary market, the seller receives interest up to, but not including, the settlement date from the buyer

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agency/GSE

agency bonds are issued by U.S. government bodies, like Tennessee Valley Authority (TVA); Government Sponsored Enterprise (GSE) bonds are offered through an act of Congress created to assist groups of borrowers; the principal and interest of GSE bonds are not guaranteed by the U.S. government

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Build America Bonds (BAB)

a category of taxable municipal bonds which can be one of two types; the first type provides a Federal subsidy through Federal tax credits to investors in the bonds; the second type provides a Federal subsidy through a refundable tax credit paid to state or local governmental issuers

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coupon

the interest rate a bond's issuer promises to pay to the bondholder until maturity, or other redemption event; generally expressed as an annual percentage of the bond's face value

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corporate bond

a debt security issued by a private corporation; interest is taxable and is generally paid according to a coupon rate set at the time the bond is issued; generally have a face value of $1,000 and a specific maturity date

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creditworthiness

measurement of the risk of default of an individual fixed-income security or the issuer of a fixed-income security; generally measured by one of the major ratings agencies

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debt obligation/principal

an interest-bearing promise, to pay a specified sum of money (the principal amount) on a specific date; bonds are a form of debt obligation; categories of bonds are: corporate, municipal, treasury, agency/GSE

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default

occurs when a bond issuer fails to make either an interest payment or principal repayment on its bonds as they come due, or fails to meet some other provision of the bond indenture

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extraordinary redemption

a provision which allows a bond issuer the right to call its bonds before maturity if certain specified events occur (as specified in the offering statement), such as natural disasters,cancelled projects, to almost anything else

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face value

the stated value of an investment at maturity; the face value for a corporate bond is typically $1,000; also known as par value or par amount

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fixed income

a type of asset class in which the investments provide a return in two possible forms; coupon paying bonds have fixed periodic payments and a return of principal; zero coupon bonds are sold at a discount, do not pay a coupon, and have a return of principal plus all accumulated interest at maturity

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indenture

a contract that explains the various terms, options and intricacies of a bond

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interest

the amount paid by a borrower to a creditor, or bondholder, as compensation for the use of borrowed money

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interest income

the dollar amount of all interest earned on government and corporate debt obligations and short-term certificates of deposit, as well as interest earned from cash in a brokerage account

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interest rate

the annual rate, expressed as a percentage of principal, payable for use of borrowed money

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issuer

a government, corporation, municipality, or agency that has issued a security (e.g., a bond) in order to raise capital or to repay other debt; the issuer goes to an underwriter to get their securities sold in the new issue market; for certificates of deposit (CDs), this is the bank that has issued the CD; in the case of fixed income securities, the issuer of the security is the primary determinant of the security's characteristics (e.g., coupon interest rate, maturity, call features, etc.)

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maturity, maturity date(s)

the date on which the principal amount of a fixed income security is scheduled to become due and payable, typically along with any final coupon payment. It is also a list of the maturity dates on which individual bonds issued as part of a new issue municipal bond offering will mature

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Moody's

an independent organization that assigns credit ratings to debt instruments and securities to help investors assess credit risk

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municipal general obligation bond

a type of municipal bond backed by the full faith, credit, and taxing power of the issuer, specifically its ability to collect taxes; may only be issued by entities that have the right to levy and collect taxes

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Original Issue Discount (OID)

the difference between the stated redemption price at maturity (if greater than one year) and the issue price of a fixed-income security attributable to the selected tax year

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prospectus

a legal document required by the Securities and Exchange Commission (SEC) that discloses an investment's objectives, past performance, and other information to parties considering investing in financial instruments such as stocks, bonds, mutual funds, etc.

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principal repayment

the payment of the face value of a bond or CD by the issuer, this can be due to the securities reaching maturity date, or because the issuer redeemed the securities prior to maturity due to a call or other form or redemption

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redeem

the act of an issuer calling, or purchasing a fixed-income security from the holder, generally at face value, prior to the stated maturity date

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Treasuries

debt obligations of the U.S. government that are issued at various intervals and with various maturities; revenue from these bonds is used to raise capital and/or refund outstanding debt; since Treasury securities are backed by the full faith and credit of the U.S. government, they are generally considered to be free from credit risk and thus typically carry lower yields than other securities; the interest paid by Treasuries is exempt from state and local tax, but is subject to federal taxes and may be subject to the federal Alternative Minimum Tax (AMT); U.S. Treasury securities include Treasury bills, Treasury notes, Treasury bonds, zero-coupon bonds, Treasury Inflation Protected Securities (TIPS), and Treasury Auctions

Questions?

Fidelity Learning Center

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties.
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