Municipal bonds are debt obligations issued by state and local governments to finance public projects like roads, schools, and sewer systems. As bonds, their primary purpose is to pay income to the owner. Bonds are issued for specific timeframes during which they usually pay a fixed amount of income to the holder and, at maturity, pay back the original principal face value. Municipal bonds are generally considered the safest investment short of US Government debt obligations because, generally, the bonds are paid for either by residents of the municipality or by projects funded to incent corporations to locate there to benefit the residents.
Municipal bonds pay regular income that is, generally, free from federal income tax and may also be exempt from state and local income taxes as well. (Other taxes, like capital gains tax or the Alternative Minimum Tax may apply.) While municipal bonds may pay a lower nominal interest rate than taxable bonds, the taxable-equivalent interest rate usually makes municipal bonds more attractive for investors in higher income brackets.
Many municipal bonds, and specifically general obligation bonds, are backed by the full faith and credit and taxing power of the municipality that issued them. A great example is schools; usually schools are built using money raised by selling municipal bonds to the investing public. Then, as homeowners in the school district pay their property taxes (an almost-certainty due to the threat of losing their home) the bonds’ interest payments are made to bond holders. Other examples are water and sewer system users, roads, and community development projects like libraries and parks.
While there is a very large and active marketplace to purchase individual municipal bonds, there are also products available that provide geographic diversification, variable monthly incomes, and defenses against the primary threat to bondholders – higher interest rates – and the opportunity to participate in those higher interest rates using active management.
The principal of our firm spent his first decade in the investment business working for a firm whose primary business was underwriting and selling municipal bonds to individual and institutional accounts. Our experience in the muni market spans nearly 40 years and, today, nearly half of the firm’s assets under management are in municipal bond products (our Managed Municipal Products models).