How Do City Bonds Work?

Many city governments find themselves up against a wall when they need money for day-to-day operating expenses, building new structures, improving existing structures or making repairs. Ongoing expenses, including employee wages, maintenance and insurance, plus periodic projects including building schools, improving roadways and ensuring the safety of bridges, represent significant costs for city governments. To pay for these costs, a city’s resources include licensing fees and tax payments. But there are times when city budgets simply cannot sustain the city’s operating costs and city coffers come up shorthanded (or empty-handed) to cover expenses or fund needed projects. During times like these, government officials often turn to city bonds as a resource for raising the money.

What Is a Municipal Bond?

Also called muni bonds, or munis, municipal bonds are debt securities. They’re issued by different types of government entities including states and counties. City governments also issue municipal bonds, which are simply called city bonds. Investors earn money on city bonds when the city pays interest on the investment at certain intervals, which are defined in the bond parameters. Bond investors are essentially lending money to a city in return for the interest income they make on the city bonds. And on the maturity date of the bond, the city returns an investor’s initial investment.

Interest Rates and Interest Payments

Bond interest rates are also called coupon rates, and they are typically fixed rates; they do not fluctuate or adjust over the life of the bond. Interest rates follow market trends and can vary widely, depending on which bonds you choose as investments. An interest rate of, for example, 2.3 percent, may not sound very high, but when coupled with the tax-free benefits you'll receive, the actual overall return on your investment could be 6.5 percent or more. And higher coupon rates will yield higher dividend yields. Because of the tax break, the interest rate for city bonds is lower than other types of taxable bonds such as corporate bonds. City bond investors typically receive interest payments on a semi-annual basis – every six months.

Maturity Dates

Municipal bonds have widely varying maturities from one year to 30 years. Serial bonds are groups of bonds that mature at different intervals during the series. The series may span 20 years with different maturity dates at each year during the series. Term bonds typically have longer maturity dates; for example, 20 to 30 years. A term bond is usually repaid at a single maturity date or during limited intervals. Although investors can sell municipal bonds before their maturity dates, investors will not receive their full return on investment unless the bonds reach their maturities.

City Bond Yields

The return on investment of a city bond is called its yield. The current yield represents the interest payments you receive, expressed as a ratio of the dollar amount of interest paid in a year to its purchase price, converted to a percentage. The yield-to-maturity represents the total amount of money you’ll make in principal and interest over the life of the bond if you hold it to its maturity. Yield-to-call represents the return on your investment if the city “calls,” or pays your bond in full before its maturity date.

Types of City Bonds

Cities may issue bonds on behalf of other entities such as hospitals or non-profit schools. These entities are called "conduit borrowers," and they repay the city for the amount of principal and interest that the city pays to the investors of the bond. If, however, the conduit borrower fails to make its payment to the city, the city typically is not required to pay the investors.

More often, as noted by the U.S. Securities and Exchange Commission (SEC), cities issue two common types of municipal bonds:

1. General obligation bonds. These bonds are unsecured by any assets, instead relying on the "full faith and credit" of the issuing city. The city has the authority to tax its residents to pay the bondholders. The historical first issuing of a general obligation bond was in 1812 when New York City issued a bond to fund a canal.
   
2. Revenue bonds. These bonds are backed by the revenues that a specific project generates, such as a highway toll, instead of by taxes imposed by a city's government.
   

Examples of City Bonds

You may be familiar with municipal bonds because of their appearance on your local tax ballot through a process called a bond referendum. Because bonds can raise taxes, which allows the city to pay the investors (or bondholders), some cities let their voters decide the fate of some bond issues. For example, if the city is considering a new school, it may let its voters decide whether to approve a bond that would fund the school. In other cities, the city government doesn’t have a choice about allowing voters to decide the fate of certain bond issues if the city’s constitution or local ordinances mandate that the taxpayers must cast the deciding vote. Bonds can also raise money to build city airports or repair infrastructures such as roads and bridges.

Tax-Exempt Advantages

City bonds are attractive to many investors because of their tax-exempt benefits. Typically, the interest income you make from your investment in a city bond is not only exempt from federal income tax, but it’s often exempt from state and local taxes as long as you live in the state where a bond is issued. The SEC recommends talking to a tax professional if you're considering investing in a municipal bond to find out if the bond is eligible for tax-exempt benefits.

Forbes offers an example of how the apparent low-interest rate of some bonds actually translates to significant tax savings: If you invest in a municipal bond that pays 5 percent interest, your actual tax savings – if it’s tax-exempt – is higher. If you’re in the 28 percent tax bracket, you’d have to invest in stocks or corporate bonds at nearly 7 percent interest to find a comparable return on your investment. The reason is that these investments are not tax-exempt, so you’ll pay taxes on your interest income.

Another benefit of investing in city bonds is that purchasing and holding municipal bonds does not move you into the next higher tax bracket because of the interest income.

Tax-Exempt Exceptions

You'll catch a tax break from federal and some state income taxes if you invest in city bonds, but your investment is not always completely free from other tax liabilities, namely:

• State taxes. If you invest in a bond that's issued by a state other than where you live, you'll typically pay taxes on your interest income. But if you invest in a bond that's issued by the state where you live, you're generally exempt from state taxes on the interest income you make. But this isn't always the case. Some states do assess taxes on certain types of bonds for resident taxpayers.
  
• Federal taxes. Some municipal bonds are not federally tax-exempt. An example is a bond that may be issued to help fund a struggling pension plan.
  
• De minimis taxes. If you purchase a bond at a discount, you may owe taxes on the difference between the amount you paid and the bond's market value, or par value.
• Alternative minimum tax (AMT). Some interest income from municipal bonds is subject to the AMT liability. This calculation is often complicated and difficult for most taxpayers to understand. Consulting a tax professional can help clear the muddy water on this one.
• Higher tax on Social Security benefits. The IRS includes interest income from municipal bonds in your modified adjusted gross income (MAGI), which may increase your Social Security tax liability.
• Higher Medicare premiums. Your interest income from municipal bonds may also cause your MAGI to increase the amount you pay for Medicare Part B or Medicare prescription drug coverage.
• Capital Gains tax. If you sell a municipal bond before its maturity date and you receive a payment that's greater than your purchase price, which is adjusted for paid premiums and received discounts, you'll have to pay tax on the amount of gain you realized.

City Bond Investment Risks

Just as there are risks associated with any investment, there are potential risks associated with investing in city bonds, among them:

• Call risk. Each city bond has different parameters, both for the issuing city as well as the investor. If the wording in your particular bond allows the city to "call" or repay the bond earlier than its maturity date, you will not make the full return on your investment that you expected. The SEC notes that many bonds have a "callable" option.
  
• City credit risk. A city bond that's backed by the city's credit can run afoul if the city experiences financial difficulties. One solution is to find out if the bond you're considering purchasing has a credit rating for the city. While a strong credit rating is not a guarantee that the city will default, it may help you make your investment decision.
  
• Interest rate risk. Over the life of your bond, until its maturity, you're typically locked into a fixed interest rate. Market fluctuations may mean that a long-term bond – for example, 20 or 30 years – may not pay as much as other, short-term investments for which you can adjust your investments to fit rising or lowering interest-rate trends. For example, when market interest rates rise, the market value of your bond goes down. But you'll be locked into your lower-interest-rate bond instead of moving your money into a higher-interest vehicle unless you sell your bond before its maturity date. And if you sell before maturity, you'll lose more of the bond's value as well as incurring capital gains taxes.
  
• Broker risk. When you purchase your bond through a broker or other adviser, your investment is often only as strong as the broker's credentials. The SEC recommends making sure your broker is properly licensed and registered. You can check credentials of potential brokers by visiting the SEC at Investor.gov.

Mitigate the Risks

Instead of investing into one particular city bond, an option is to invest into bond funds. These funds are comprised of many bonds and other securities rolled into one account, which is one type of mutual fund. Bond funds can help mitigate the risk of putting all your city fund investment eggs into one basket by spreading your investment over a diversified portfolio. Typically, bond funds do not have specific maturity dates, and they pay interest monthly. Whether you're looking at volatile market conditions or simply considering your own cautious nature (or both), bond funds offer a measure of stability that you won't likely find in an individual city bond investment.