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A municipal bond is a bond issued by a city or other local government, or their agencies. Municipal bonds may be general responsibility of the issuer or secured by specified revenues. Interest income received by holders of municipal bonds is regularly exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for definite purposes may not be tax exempt.
Municipal bonds are issued by states and cities, or their agencies (the municipal issuer) to increase funds. The methods end traces of issuing debt are governed by an extensive system of laws and regulations, which differ by state. Bonds bear interest at either a fixed or variable rate of interest, which can be subject to a cap known as the highest legal limit. If a bond calculate is proposed in a local county election, a Tax Rate Statement may be provided to voters, detailing best estimates of the tax rate required to levy and fund the bond.
The issuer of a municipal bond obtains cash payment at the time of issuance in exchange for a promise to refund the investors who provide the cash payment (the bond holder) over time. Repayment time can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer. The issuer typically uses proceeds from a bond sale to pay for capital projects or for other purposes it cannot or does not wish to pay for immediately with funds on hand. Tax regulations governing municipal bonds usually require all money raised by a bond sale to be spent on one-time capital projects within three to five years of issuance. Certain exceptions authorize the issuance of bonds to fund other items, including ongoing operations and maintenance expenses, the purchase of single-family and multi-family mortgages, and the funding of student loans, among many other things. Because of the special tax exempt status of most municipal bonds, investors generally accept lower interest payments than on other types of borrowing. This makes the issuance of bonds an attractive source of financing to many municipal entities, as the borrowing rate existing in the open market is regularly lower than what is available through other borrowing channels.
Municipal bonds are one of some ways by which states, cities and counties can issue debt, other mechanisms include certificates of participation and lease-buyback agreements. While these methods of borrowing are different in legal structure, they are similar to the municipal bonds described in this article.
Municipal bond holders may buy bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an upfront investment of capital, the bond holder obtains payments over time composed of interest on the invested principal, and a return of the invested principal itself. Repayment schedules vary with the type of bond issued. Municipal bonds naturally pay interest semi-annually. Shorter term bonds usually pay interest only until maturity; longer period bonds usually are amortized through annual principal payments. Longer and shorter period bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, such as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.
One of the primary reasons municipal bonds are considered separately from other types of bonds is their special capacity to provide tax-exempt income. Interest paid by the issuer to bond holders is frequently exempt from all federal taxes, as well as state or local taxes depending on the state in which the issuer is located, subject to certain restrictions. Bonds issued for certain reason are subject to the alternative minimum tax.
The type of project or projects that are funded by a bond affects the taxability of revenue received on the bonds held by bond holders. Interest earnings on bonds that fund projects that are constructed for the public good are usually exempt from income tax, while interest earnings on bonds issued to fund projects partially or wholly benefiting only private parties, sometimes referred to as private activity bonds, may be subject to income tax.
The laws governing the taxability of municipal bond income are complex; but, bonds are typically certified by a law firm as either tax-exempt or taxable before they are offered to the market. Buyer of municipal bonds should be aware that not all municipal bonds are tax-exempt.
The risk of a municipal bond is a measure of how likely the issuer is to make every payments, on time and in full, as promised in the agreement between the issuer and bond holder (the "bond documents"). Different types of bonds are secured by different types of repayment sources, based on the promises made in the bond documents :