by Matthew Marcus

Created on: September 06, 2008   Last Updated: September 16, 2008

Odds are that in a recent election you have voted to authorize the city or county that you live in to issue bonds in order to raise capital for a public works project, or to fund a city department. So exactly what are municipal bonds?

In simple terms, a municipality, or a city, will borrow money from a bonding company at a specific interest rate. The city will pay back the loan, plus interest, through its tax revenues. Instead of just collecting the money and interest, the lender will sell the rights to collect the repayment in the form of tax-free municipal bonds. These are generally desirable to investors since they are not subject to taxation, and they generally provide secure rate of return on investment, since the bonds are paid back by tax revenue.

The sale of bonds is controlled by the Securities Exchange Commission (SEC) which is a body authorized by the United States Congress to set and enforce guidelines for bonding and the sale of bonds. Due to several cases in the past where major municipalities have defaulted on the repayment of loans, the municipal bond market is tightly controlled, and therefore municipal bonds are difficult for the public to purchase directly. The first tier of investors generally consists of banks and dealers.

Although investing in municipal bonds directly is difficult, it is possible to invest in municipal bonds through bond funds. Bond funds will offer high-yield municipal bonds, or high-quality municipal bonds. The high-quality bonds represent loans that are deemed "more secure" by the bonding agency, and thus they return a lower rate of interest. Conversely, high-yield bonds are generally deemed as "less secure" by the bonding agency, and thus they return a higher rate of interest.

When planning to invest in bonds or bond funds, it is a good idea to talk to a financial advisor, or to do thorough research on your own. Bond ratings can often be misleading, and they are not necessarily as safe as one would think. The main down-side to bonds is that if the prime lending rate goes above the rate of return of the bond, then holding the bond becomes undesirable for the banks, since they can obtain a better rate of return by holding debt at the current interest rate. In this case the face value of the bond will actually decrease as the banks try to change their position by selling off the bonds at the lower rate of return.

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