Flow of Funds Overview: Municipal Bonds

Municipal Securities

Debt instruments of state and local governments

Municipal securities and loans are debt obligations of state and local governments, mainly long-term.

Overview: Flow of funds: Municipal Bonds

The principal buyers are individual investors (households), property and casualty insurance companies, and mutual funds (including money market funds).

Like corporate bonds, most municipal securities are rated by one of the major rating agencies.

Taxpayer Incomes Support Municipal Securities

Payment of interest and principal on municipal securities comes primarily from state and local taxes, although some bonds are secured by other revenues such as tolls on bridges and roads.

Like other bonds, municipal securities are traded in the over-the-counter market.

Many municipal bonds have third party guarantees by insurers on payment of principal and interest in the event of default.

Municipal bonds are subject to credit risk, interest rate risk, and call risk.

Partial Exemption From Federal Tax

Most municipal securities are exempt from federal income tax and bond prices reflect this tax advantage as well as the credit risk of the issuing government.

The infrastructure of American cities is financed by municipal bonds.

Many municipal bonds are also exempt from state and local taxes.

Although exempt from income tax, income from municipal securities may incur the Alternate Minimum Tax.

Many Kinds of Municipal Bonds

The main types of municipal bonds are:

  1. general obligation bonds backed by the full faith and credit of the issuing authority;

  2. revenue bonds backed only by income from a specific project;

  3. insured bonds;

  4. bonds sold at a discount at original issue, with the discount exempt from taxation if held to maturity;

  5. taxable municipal bonds;

  6. zero coupon bonds;

  7. refunded bonds, collateralized by U.S. Treasury securities or some other types of security;

  8. pre-refunded bonds, scheduled to be called;

  9. escrowed-to-maturity bonds, not scheduled to be recalled;

  10. housing bonds, backed by mortgages; and

  11. municipal notes, usually coming due in one year or less. There are derivative securities linked to the municipal bond market.

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