Investment Securities - Municipal Bonds
When state and local governments or U.S. territories need to raise money, they may issue municipal bonds. Municipal bonds, commonly referred to in investing circles as munis, are considered second only to U.S. government and agency securities in safety of principal.
The article The is an excellent primer on the types of municipal bonds, and buying strategies.
Types of Municipal Bonds
Municipal bonds are classified into two categories, based on where the issuing entity gets the money to pay bondholders. These are general obligation bonds and revenue bonds.
General Obligation (GO) Bonds - Only entities that have the ability to levy and collect taxes can issue GO bonds. They are usually issued to fund properties or facilities used by the public, such as government buildings, schools, prisons and police and fire stations. Local governments depend upon property taxes (ad valorem taxes) to pay the obligations of their debt securities, while state-issued GO bonds are paid from income, sales, income and other taxes, as determined by the state legislature.
Limited tax GO bonds are issued by school districts, which have a legal limit on the amount of taxes they can impose. Other government units that have no legal limitation on their power to tax issue unlimited tax bonds.
A municipality's financial safety and stability is usually based on four factors:
- Tax burden on and source of tax payments for the issuer
- Budgetary structure and financial condition of the issuer
- Existing issuer debt, as measured by net debt per capita and overlapping debt
- Overall economic health of the community, including changes in property values, average household income, size of the employer pool and other demographics
Revenue Bonds - Revenue bonds are backed by user fees and other charges generated by a particular public works project. They are commonly used to finance the following endeavors:
- Colleges and universities
- Toll roads and bridges
- Public power systems
- Sewer and water systems
- Housing developments
- Sports facilities and convention centers
- Rapid transit
- Industrial development
For example, a state may issue revenue bonds to fund the construction of a new sports stadium and convention center. The revenue generated from facility use such as sporting event ticket sales, parking fees, concert concessions, reservation fees for trade events and so on will go towards paying the interest and principal on the bonds.
The quality of a revenue bond issue depends on whether the project it funds can generate enough cash to pay the interest and principal on the bonds. Analysts will look at the flow of funds, which is how the revenues generated from the project are distributed.
- A net revenue pledge means that the revenues are allocated to operating and maintenance expenses first, and to the debt service (i.e. to the bondholders) next.
- A gross revenue pledge means that the bondholders will be paid first. An analyst will also compare the revenue available to pay debt service to the amount of interest due (called debt service coverage).
The analyst will also ask the following questions:
- Can the issuer raise the rates that it charges without outside approval?
- What are the competing facilities
- Does the local government have the right to use the project's revenues for any other purpose?
- What circumstances would allow the project to issue new bonds that would take up a part of its revenues? (This is known as the additional bond test.)
Know the difference between GO bonds and revenue bonds and the funding sources for each one!