• Bond Basics

  When a municipal issuer borrows funds for a public purpose, it often does so through the capital markets by issuing bonds. This usually involves working with broker-dealers and banks, as underwriters, who agree to purchase all of the bonds offered by the issuer and then to resell those bonds to investors. The moneys paid by the underwriters to the issuer for the purchase of the bonds represent the loan proceeds that the issuer will use for its public purposes. Underwriters generally do not retain the bonds but instead market them to investors, who effectively become lenders to the issuer and who receive the loan repayments as payments of principal and interest on the bonds. Many different types of investors invest in the municipal securities market, ranging from individuals, banks, insurance companies, trusts, mutual funds, hedge funds, corporations, foreign entities and others.

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• Buying and Selling Bonds

  Municipal bonds may be purchased in the initial offering of the bonds, typically through broker-dealers or banks that underwrite the bonds or assist the underwriters to distribute the newly issued bonds (a "primary market" transaction), or in the "secondary market" following the initial issuance. Virtually all buying and selling by customers occurs with the assistance of broker-dealers or banks who are subject to MSRB rules, although occasionally an issuer may establish special direct-to-investor bond offerings that allow investors to purchase directly from the issuer.

  New Issue Transactions—In new issues, list offering prices typically are disclosed as the prices at which a substantial portion of the issue was offered to the public. Thus, many – but by no means all – primary market trades during the initial distribution of a new issue will occur at this list offering price. The issuer’s official statement is intended specifically for new issue customers and serves as the primary source of information about the issuer and the securities for primary market transactions.

  Under MSRB rules, underwriters are required to provide copies of the official statement to new issue customers and to submit the official statement to the MSRB. In addition, any amendments or supplements prepared by the issuer during the first 25 days after the initial issuance also must be submitted by the underwriter to the MSRB. Official statements and amendments or supplements are publicly available through EMMA. For securities that are in the new issue period, EMMA provides an indicator flag and also allows the public to request to be notified if the official statement or any amendment or supplement has been posted on EMMA for such new issue.

  Secondary Market Trades—Most municipal securities trades occur in the secondary market. In effect, investors who buy municipal bonds in the initial public offering may choose to sell the bonds rather than to hold the bonds until maturity. This generally serves as the beginning of secondary market trading in such bonds.

  There are approximately 60,000 different issuers of municipal securities, and many of these issuers may issue different types of securities. This wide array of choices in the municipal market contrasts sharply with the corporate market, where the number of issuers and issues is much smaller. Due largely to this extraordinary variety, municipal bonds have historically traded in an "over-the-counter" market, rather than on an exchange, and the vast majority of municipal bonds are not traded on a regular basis. Unlike when investing in stock through an exchange where the investor can buy the securities of a specific company at any time due to the general availability of shares for sale, an investor seeking to invest in a specific municipal bond is not likely to easily find a ready seller of that specific bond, with limited exceptions for some large more actively traded issues. It is much more common to identify basic characteristics of a municipal bond in which an investor is interested in investing (e.g., state, credit worthiness, maturity range, interest rate or yield, market sector, etc.) and then to make a choice from among a set of municipal securities then available for purchase that meet those criteria.

  Principal Trades—Historically, when a customer buys or sells a municipal bond, that trade occurs with a broker-dealer or bank acting as the other party, or "counter-party," in a "principal" trade. An investor may purchase a bond out of "inventory," meaning bonds that the broker-dealer or bank already owns with the expectation of later selling, or the broker-dealer or bank may acquire the bond from another broker-dealer, bank or investor for resale to its customer. Principal trades are usually done without a commission charge, with the broker-dealer or bank instead realizing profit or loss through the purchase by the broker-dealer or bank of the security and the re-sale of that security at a higher price to the customer.

  Agency Trades—Agency trades, where the broker-dealer or bank is an intermediary between the buyer and seller and does not take ownership of the securities, are much less common in the municipal securities market. For one thing, it is often difficult to find someone interested in buying a specific municipal bond just when someone else is interested in selling that bond. A broker-dealer or bank typically charges a commission when serving as an agent between two counter-parties to a trade.

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• Tax Treatment of Bonds

  Tax-Exempt Bonds—Perhaps the most well-known characteristic of municipal bonds is that interest typically is exempt from federal income tax, and thus municipal bonds often are referred to simply as "tax-exempt bonds." For interest on a municipal security to be exempt from the investor's gross income for federal income tax purposes, the issuer must meet a number of requirements in the federal income tax code and regulations. The official statement for new issues of municipal securities generally includes a statement on the cover that the bonds are tax-exempt, and the official statement also typically includes the opinion of bond counsel addressing, among other things, the federal income tax exemption.

  Taxable Munis—There are some cases in which a municipal security is not tax-exempt. Such "taxable munis" can result if the securities are issued to raise funds for a project that does not meet certain public purpose or public use tests under the federal tax rules. The official statement for new issue taxable munis generally includes a statement on the cover to that effect, and the opinion of bond counsel included in the official statement usually states that the securities are not tax-exempt.

  AMT Bonds—In some cases, municipal securities may enjoy the federal tax exemption under the ordinary federal income tax calculation but are nonetheless subject to the federal alternative minimum tax, or AMT. In that case, some of the benefits of tax-exemption may be lost for taxpayers who are subject to the AMT. Such "AMT bonds" are issued as “private activity bonds” for the benefit of certain private entities, although some types of private activity bonds (such as bonds issued for private tax-exempt organizations) have been excluded from the AMT. The official statement for new issues AMT bonds generally includes a statement on the cover to that effect, and the opinion of bond counsel included in the official statement usually states that the securities are exempt from federal income tax but are subject to the AMT.

  State Tax Treatment—A state may provide an exemption from state income tax for interest on investments by its residents in bonds issued by the state or any other municipal issuer within the state. The specific provisions and conditions of such exemption vary from state to state and not all states provide an exemption. Many states that provide a state income tax exemption for in-state investments do not provide a similar exemption for investments by their residents in municipal bonds issued by issuers outside of the state. This practice has been challenged in court and there is currently a case pending before the United States Supreme Court (Department of Revenue of Kentucky v. Davis, Case No. 06-666).

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• How Bonds Are Secured

  The interest and principal of bonds must be repaid to investors, and the legal documents set out the pledge and legal commitments of the issuer and others in connection with repaying all amounts owed to investors.

  Issuer's Pledge—Municipal issuers promise to repay bonds out of a broad variety of funding sources. For example, in some cases, an issuer may promise to make payments out of any funds it has available, including funds available through its power of taxation. These are generally referred to as "general obligation bonds" or "full faith and credit bonds." In other cases, the pledged sources may be limited to a specific form of taxation (a "limited tax bond") or to revenues generated by a specific facility or system (a "revenue bond"). When only a specific source is pledged to pay the bonds, the issuer generally will not be obligated to use any other source to repay the bonds if the pledged source proves to be inadequate. Depending on the issuer, there may be numerous variations on each of these types of bonds or other types of pledges toward payment of the bonds.

  Third Party Beneficiary's Pledge & Private Activity Bonds—Municipal issuers often issue bonds for the benefit of one or more private entities that will use the funds for purposes that the issuer views as furthering the public interest. These private activity bonds may be issued for projects such as not-for-profit hospitals, single and multi-family housing, airports and seaports, solid waste disposal facilities, student loan programs, redevelopment programs, and various other purposes. For these issues, the bond proceeds are used to finance loans to fund the specified purposes, and the issuer pledges payments it receives on these loans to repay the bonds. Unless otherwise provided, private activity bonds are solely payable from funds of the private beneficiary and the issuer generally will not be obligated to use any other source to repay the bonds if the payments from the private beneficiary prove to be inadequate.

  Bond Insurance, Letters of Credit, and other Guarantees—Issuers often obtain third-party credit enhancement to backstop the primary source of revenue pledged to repay the bonds. The most common form of credit enhancement used in recent years is bond insurance. When an issuer obtains bond insurance, a copy of the policy typically is included in the official statement. Another form of credit enhancement is a letter of credit issued by a bank, which can be drawn on to make payments on the bonds if the primary source of pledged revenues is inadequate. Insured bonds and bonds backed by letters of credit often carry two separate ratings, one of which is based on the financial strength of the insurer or bank and the other "underlying" rating is based on the financial strength of the issuer (and, in some circumstances, on the structure of the bond issue). In other cases, a guarantee is provided by a related third-party, such as another unit of government or, in the case of private activity bonds, a parent corporation or other entity related to the private beneficiary of the bonds.

  Letters of credit used to provide credit enhancement should be distinguished from those used as "liquidity facilities" to ensure that investors are able to exercise their "put" options in connection with variable rate demand obligations, as described below.

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• Types of Bonds & How Bonds Pay

  Interest Payments and Categories of Bonds—Investors receive interest payments on bonds in various forms, depending on the category of bond:

  • fixed rate bonds—The traditional form of bond pays a fixed rate of interest until maturity. This will be stated as the bond's interest rate or "coupon" rate. Fixed rate bonds typically pay interest semi-annually on specific interest payment dates. For example, if you own $10,000 of a bond with a coupon rate of 5%, you typically would be paid $500 of interest annually, payable in semi-annual installments of $250.
  • variable rate demand obligations or notes—Another common form of bond pays interest based on a variable rate, that is, a rate of interest that is adjusted from time to time. These types of bonds are often referred to as variable rate demand obligations or notes. In many cases, these “VRDOs” will have a maturity date far into the future but are treated as short-term investments because an investor is given a "put" right, or the right to require that the issuer or its agent repurchase the bonds from the investor at the full face value of the bond.

  There are many different ways in which the interest rate can vary, which will be spelled out in the bond documentation for the VRDOs. Often, interest rates will be reset on a specific schedule of periodic adjustments based on the best estimate of a broker-dealer or bank, acting as remarketing agent, of the rate in the then-current marketplace necessary to allow the bonds to be resold to investors at their full face value. For other variable rate securities, the rate adjustments may be based on a formula pegged to a financial market rate index or other interest rate measurement. The periodic resets typically can occur daily, weekly, monthly, semi-annually, annually, or even less frequently.

  The frequency of interest payment for variable rate bonds typically is dependent on the frequency of the periodic interest rate resets. A typical pattern is for daily, weekly and monthly resets to pay interest on a monthly basis (for example, on the first business day of each month), while variable rate bonds with reset frequencies of semi-annually or less frequently will typically pay interest on a semi-annual basis.

  • auction rate securities—Auction rate securities also pay interest at a rate that adjusts from time to time, with the periodic interest rate determined through a modified auction process. This process typically involves determining which current owners wish to sell their holdings or to retain their holdings (and whether the election to retain is conditioned on meeting a specified new interest rate threshold) and gathering bids from potential new investors (which in many cases may include bids entered by a broker-dealer or bank involved in orchestrating the bid process, if permitted under the bond documentation) who indicate the interest rate at which they wish to purchase the securities. If there are a sufficient number of purchase bids to match the offered sales on the terms indicated in the bids and offers, the auction will succeed and the interest rate for the next rate period will be set at the lowest "clearing" rate necessary to achieve such matching. Otherwise, the auction will fail, current owners of the securities will retain their ownership, and the interest rate for the next rate period will be set at the "fail" rate, which typically is a relatively high rate. If no current owners of the securities wish to sell at an auction, they will retain ownership and the interest rate for the next rate period will be set at the "all-hold" rate, which typically is a relatively low rate.

    An important distinction between auction rate securities and variable rate demand obligations is that investors in auction rate securities do not have a "put" right. Thus, there is no assurance that the investor will be able to sell its holdings during an auction. Instead, investors are dependent on the success of the auction process. Among many other factors, the pool of purchase bids that may be entered can vary widely from auction to auction, and bids entered by broker-dealers, banks and other market professionals that have the effect of supporting market liquidity, if permitted, generally are not required under the legal documents and therefore investors cannot be assured that such bids will be entered in any particular auction. Investors also should be aware that it is possible to trade auction rate securities away from the auction process, although the price realized in such trades will be set in a manner other than as envisioned through the auction process and may not occur at par.

  • short-term notes—In some cases, municipal issuers will sell notes that mature relatively soon after issuance, sometimes less than one year after issuance. For these types of short-term notes, issuers sometimes will forego an interim payment of interest prior to maturity but instead will pay all interest at maturity of the note.
  • zero-coupon bonds or capital appreciation bonds—Some bonds do not pay interest periodically but instead accumulate interest earnings until the bond matures, at which point the principal and all accumulated investment earnings are paid. In this case, the bond will typically be sold having an initial principal amount and a separate maturity amount, with the difference between these two amounts effectively representing your interest earnings.
  • discount bonds—Issuers will sometimes issue bonds that have a fixed rate of interest payable on a semi-annual basis but will sell the bonds at a discounted price, or at an "original issue discount." For example, an issuer may sell $10,000,000 of bonds with a coupon rate of 5% at a price of $9,950,000, generally referred to as a price of 99.5%. An investor who purchased the bond at original issuance at the discounted price who holds this bond until maturity will be paid the full face amount of the bond. The difference between the discounted price and the full face amount of the bond will effectively represent interest earnings on the bond, in addition to the periodic interest payments received by the investor over the life of the bond. Investors should note that there may be significant differences in federal tax treatment of the discount on a bond between bonds sold with an original issue discount—that is, where the discount was initially structured as part of the offering by the issuer—and bonds sold in the secondary market at a price below 100%, generally representing a market adjustment in the value of the bond. Secondary market discounts may sometimes not be treated as tax-exempt interest earnings.
  • premium bonds—Similarly, issuers will sometimes issue fixed rate bonds at a price above 100%, or at an "original issue premium." In such a case, an investor who purchased this bond at original issuance at the premium price who holds this bond until maturity will be paid the face amount of the bond, which will be less than the original purchase price. Although the investor will receive periodic interest payments over the life of the bond as with any other bond, the difference between the premium price and the face amount of the bond will effectively reduce the total overall returns received by the investor. As with discount bonds, federal tax law may provide different treatment for original issue premium bonds and bonds traded in the secondary market at a premium above par.

  Principal Repayment at Maturity—Investors generally receive repayment of the principal amount of the bonds at the maturity of the bonds, although many bonds may be redeemed prior to maturity as described below.

  Early Redemption of Securities—In many cases, principal can be pre-paid by the issuer through a process of redemption, as described below:

  • sinking fund redemption—In some cases, particularly in the case of bonds maturing far into the future, a portion of the principal amount of the bonds may be subject to prepayment by the issuer based on a predetermined schedule of prepayments (called a "sinking fund schedule"). In other cases, prepayments may occur based on availability of funds on deposit in a fund established for the purpose of prepaying bonds, with the funds usually accumulated over time and sinking fund redemptions occurring either on a specified date in an amount equal to the accumulated funds or on whatever date the accumulated funds reach a specified amount.
  • optional redemption—A common feature of bonds is the optional call feature. An issuer may be prohibited from prepaying the bonds for a fixed period of time. After this "no call" period elapses, an issuer often is permitted to redeem the bonds early upon payment of a "call premium," the amount of such premium declining over time. One common structure for such optional call feature for long-term fixed-rate bonds is to have a 10-year no call period, with the issuer having the right to redeem the bonds after the end of this no-call period at a price of 102% of par (that is, at a 2% call premium). After a year, the call premium may be reduced to 1%, and then eliminated altogether after another year has elapsed. In the case of variable rate demand obligations and other adjustable rate securities, the issuer typically may exercise an optional call feature at a price of par (that is, without payment of any premium) in conjunction with any interest rate reset. However, many other optional redemption structures exist and are described in the official statement and other issue documentation.
  • mandatory, special and extraordinary redemption—Many bond issues also provide for redemptions upon the occurrence of certain specified events, in most cases at a price of par (that is, without payment of any premium). Such redemptions can go by any number of names, such as mandatory redemption, special redemption, extraordinary redemption, or other names. Often the issuer is required to undertake such a redemption, although in other cases the occurrence of the specified event will provide the issuer with an option to call the bonds but will not require that such option be exercised. The types of circumstances that can trigger such a redemption differ greatly from issue to issue and are described in the official statement and other issue documentation.

  Optional and Mandatory Puts or Tenders of Variable Rate Demand Obligations—Most variable rate demand obligations offer investors a "put" option that provides the investors with the right to require that the issuer or its agent repurchase the bonds from the investor at the full face value of the bond. Such optional puts generally can be exercised in conjunction with the reset of the interest rate to be paid on the securities for the next rate period. Typically, the issuer's remarketing agent will resell all securities that have been put to new investors, but in some cases a buyer cannot be immediately found and the issuer will draw on the letter of credit or other form of liquidity facility to pay the full face value of the bond to the investor who has put, or tendered, the bond. Issuers can also sometimes require that investors mandatorily tender their bonds back to the issuer, usually at a price of par and usually in conjunction with a conversion in the interest rate mode of the securities or under circumstances that would provide the issuer the right to exercise a mandatory redemption of the bonds.

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The descriptions above are generalizations and do not necessarily accurately represent the terms of any specific security. You must read the official statement and other relevant bond documents to fully understand your security.

For more information about bonds, see our frequently asked questions about bond basics.