The municipal bond market is comprised of state and local governments that issue bonds and the individuals and institutional investors who buy the bonds. Bonds are a type of debt instrument in which a bondholder acts as creditor and lends money to the issuer for a period of time. During stock market downturns, the municipal bond market often experiences higher-than-normal activity levels because many investors see bonds as safe-haven investments.
General obligation municipal bonds are issued by state or local governments to raise funds for short-term expenses. The bonds are backed by the full faith of the government that issued them. Bonds are issued with terms that range from six months to 30 years. Government entities often use funds raised from taxes to make interest payments to bondholders. Some bonds are callable, which means that the government that issued them can pay the bondholders back early.
Revenue bonds are another type of debt sold on the municipal bond market. Unlike general obligation bonds, revenue bonds are not backed with taxpayer money. Local governments use revenue bonds to fund particular projects such as the building of toll roads or hospitals. The revenue received from the projects financed through the bonds is used to make interest payments and eventual returns of principal to bondholders.
The municipal bond market appeals to people who are in high tax brackets, because earnings from municipal bonds are often exempt from income tax. Investors can reduce their overall tax burden by investing a portion of their money into tax-exempt bonds. Municipal bonds issuers are able to pay lower interest rates than businesses issuing corporate bonds because of the tax savings.
Mutual funds are an important part of the municipal bond market. Many financial advisers recommend that investors keep their investments diversified to protect themselves from losses associated with the failure of any one entity. Investment firms create mutual funds comprised of bonds from different geographic regions. People who buy individual bonds are reliant upon the issuer making timely payments, whereas one bond default within a portfolio of bonds has a minimal effect on each shareholder.
Bond rating agencies enable people investing in the municipal bond market to make informed decisions. Financial records pertaining to the bond issuer are analyzed by various rating agencies prior to bonds going being issued. Each company has its own rating system, but the safest bonds typically are given a rating such as "AAA" or "Aaa."