When most of us think of investing in bonds, we immediately picture the large corporations behind them. But municipalities -- cities, states, and townships -- can also issue bonds to raise capital for special projects, whether it's roadwork, schools, or hospital systems.
The primary benefit municipal bonds have over corporate bonds is that their interest is always exempt from federal taxes. Better yet, if you buy municipal bonds issued by your home state, you won't pay any state or local taxes, either. Here are a few more interesting tidbits about municipal bonds that might surprise you.
1. Municipal bonds precede corporate bonds
We're all so used to corporations issuing bonds that it may seem like municipalities one day decided to jump on that same bandwagon. But in reality, municipal bonds came first. In fact, the first official U.S. municipal bond was issued all the way back in 1812. Since then, municipal bonds have been used to finance numerous landmarks, including the Erie Canal and San Francisco's iconic Golden Gate Bridge.
2. It's a pretty big market
According to the Federal Reserve Board, by the end of 2015, there were $3.7 trillion in outstanding municipal bonds. That said, getting your hands on municipal bonds is harder than you'd think. Municipal bonds trade over-the-counter, which means they're not traded on a public exchange. As such, their availability is often limited, and it can be hard to know whether you're paying a fair price. Unlike stockbrokers, who are required to disclose their fees, municipal bond dealers aren't obligated to reveal how much of a markup they're charging. In fact, it's estimated that the cost of these markups can amount to $1 billion per year, with individual investors getting stuck bearing the brunt.
3. Not all municipal bonds are the same
There are two types of municipal bonds you might purchase. General obligation bonds are those used to fund public projects like parks or walkways. Revenue bonds, meanwhile, are used to finance projects that are designed to generate revenue. As such, these bonds are backed by their anticipated income. So if a city issues revenue bonds to a build a bridge and charges a toll to cross it, the toll money it collects can be used to repay bondholders.
General obligation bonds aren't backed by a specific revenue stream, but they are backed by what's known as the full faith and credit of the issuer. This means that a city issuing general obligation bonds must do whatever it takes to repay bondholders, whether it's raising taxes or liquidating assets. For this reason, general obligation bonds are generally considered the least risky of the two.
4. It's rare for municipal bonds to default
You may remember hearing about Detroit's highly publicized bankruptcy back in 2013. While municipal bondholders did take a hit when that happened, defaults in the municipal bond world are actually pretty rare. In fact, no state has defaulted on a general obligation bond since 1933, and municipal bonds are 50 to 100 times less likely to default on their obligations than corporate bonds with comparable ratings.
Defaults on general obligation bonds are even more infrequent. Between 1970 and 2011, Moody's reported only 71 defaults, and of those, only five came from general obligation bonds.
5. Municipal bonds have a high recovery rate
Nobody wants a bond issuer to default, but it's what happens afterward that ultimately has the greatest impact on investors. The good news for municipal bondholders is that the recovery rate -- the extent to which bondholders are repaid after a default -- for general obligation bonds is nearly 100%. Even Detroit's general obligation bondholders only lost out on 26% of what they should've been paid. Furthermore, recovery rates for municipal bonds are typically higher than those of corporate bonds.
What tends to further reassure investors is the fact that many municipal bonds are insured. If you hold an insured bond that defaults on either an interest or principal payment, the insurance company behind it is required to make that payment on the issuer's behalf.
Municipal bonds offer an opportunity to generate income without increasing your tax burden. But there are benefits of buying municipal bonds aside from the tax breaks, so it pays to learn more about how they work.