Intro to Municipal Bonds

Cities and Towns typically do not have enough cash available to pay for large expenses, so they borrow money. Municipal Bonds are the most common way in which the borrowing is structured.

A bond is a type of contract between two parties that specifies legal and financial terms for lending. In this case, the City of Hartford is asking to borrow money and offering to pay it back in the future.

It is traditional in the bond market for the borrower to receive all of the money up front. The borrower then pays interest twice per year at a fixed interest rate for the life of the bond. At some point in the future, when the bond is due, the borrower pays back the entire amount of the bond.

Suppose Hartford borrowed $1,000,000 at 5% for 10 years. The City would receive the $1,000,000 when the deal closed. Every six months, the City would make a “coupon payment” of half of the annual interest:

$1,000,000 * 5% * 1/2 = $25,000

In 10 years, when the bond is due, the City would pay $1,025,000 to cover the final interest payment and the full face value of the note.

Municipal Bonds are a special type of debt contract. Government entities are allowed to issue debt in which the interest income (the coupon payment) is exempt from income taxes.

The effect of this policy is to lower the interest rate for municipal bonds below that of corporate bonds. Municipalities, and therefore their taxpayers, save money by taking advantage of the lower cost of borrowing.

One thought on “Intro to Municipal Bonds”

Comments are closed.