Finance: What is a Muni Bond?

What is a muni bond? Muni bonds are bonds issued by the government. They are used to raise the money required to pay for government responsibilities like schools and roadways. Because of their nature and purpose, they are not taxed, so they make for pretty good investment opportunities for people in high tax brackets.

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Transcript

00:30

raise money. think local think townhall meetings like old folks arguing about

00:35

where to install new speedbumps. think angry local residents berating their

00:40

federal senators .though this stuff might sound like small change local government

00:45

is the backbone of the US of A. without your lovely local government you

00:50

wouldn't have sewer systems,or local roads, or that one Park you and your

00:55

friends hang out at when you're up to no good. yeah we know we've seen you on the

00:59

video camera. alright so muni bonds are a must-have in [pictures of people in parks]

01:02

society ,not a nice-to-have. and as a result we treat them specially.

01:06

that is we don't tax the interest they throw off and that's a big deal. a

01:10

corporate bond yielding 7% to investors who pay 40% tax gives investors a net

01:17

yield after taxes of 1 minus point for their times seven equals four point two

01:23

percent. well a muni bond can pay just four point three percent - ie slightly

01:28

more net than a corporate bond with the same risk and be a good deal for its

01:33

buyers. that difference of two point seven percent in interest is a huge

01:37

difference over time in the cost of capital from municipalities already

01:42

strapped for cash trying to raise money desperate to get that new sewer system [equation showing bond return rates]

01:46

in place for well you know a whole variety of reasons. and you know use that

01:50

rule of seventy two thing you here remember you divide the 2.7 and 72 ,yah

01:55

that's how many years it takes to double, okay, but what happens when a Muni can't

02:00

pay its bills, well in corporate America the bondholders just take possession of

02:04

the company operate it with new management pay off the debts they're

02:07

owed and well then sell it more or less. but with muni bonds you can't just

02:11

auction off a sewage treatment plant or a Reservoir Dam on

02:15

eBay. they'd sell it a huge discount for what money went into him like well maybe [ebay listing shown]

02:20

you sell them to a golf course developer or well maybe they just don't sell it

02:24

all there are zero residual value and yes

02:26

ouch. so muni bonds get treated with a little bit different perspective on risk

02:31

like the city is on the hook for them in different ways, and there are two basic

02:35

flavors of muni bonds as far as they're being backed. there's general obligation

02:40

bonds which are bonds backed by The Full Faith and Credit of the city, and then

02:43

there are revenue bonds backed only by sales expected to be reaped from a

02:48

specific project, say you know that new 8 story parking structure in the middle of

02:53

town which charges you 40 bucks a day to park your car.

02:56

well that 40 bucks or at least part of it would go back to repay the owners of [parking garage pictured]

03:00

the revenue bond. so why wouldn't you knee bones be backed in two different

03:04

ways? well because investors like to know what happens if the city doesn't pay

03:09

back its bills. general obligation bonds are backed by the city's ability to tax

03:14

its citizens. that's that under Full Faith and Credit thing. that is the

03:19

general obligation bonds oblige- see that's that obligation thing- they oblige

03:23

the entire city generally to pay its bills. like even if they have to double

03:28

tax the rich people in the city hoping they don't move out you know pay back

03:32

the money they borrowed. if a city ever renigs well they'll lose that Full Faith

03:37

and Credit from investors, and well good luck ever raising money again, or at

03:41

least certainly at any kind of favorable rates. with revenue bonds the backing is

03:46

narrower, the project is riskier, and usually the interest rates that come [types of muni bonds]

03:50

with it are higher. payment on these bonds comes from the revenue generated

03:55

from what the bonds were used to create. right like bonds to build a toll road or

03:59

another example here. thought it may be better than the parking authority thing

04:02

yeah okay okay. all right well the issuer can estimate fairly accurately the

04:06

revenue that will be generated from those tolls and then it's up to the [equation pictured]

04:09

investor to decide if that revenue will be sufficient enough to service the debt

04:14

on the bond. and historically muni bonds are very safe .only a handful of muni

04:19

offerings in the US have ever not paid back everything .so in the scheme of

04:23

things munis are a good risk. at least they have been as Illinois in

04:27

California begin to Teeter on the edges of bankruptcy it'll be interesting to

04:30

see what happens to the creditworthiness of their big cities, and whether they

04:34

manage to climb back up to steady ground or enjoy a nice skydive you know - the

04:39

parachute. either way Muni balance will remain one of the most

04:41

fundamental financial institutions of the US of A while a mooning bond well

04:46

that'll have to remain a personal fantasy. yes sounds look double o heaven. [person moons camera]