We all know how this one feels on the course, but that's not what we're going for here. When you buy a bond, it has a face value: that's the set price of the bond when it was issued. That bond will pay interest each year. Bonds trade like stocks, more or less and sometimes, the actual trading value of the bond goes up because investors are willing to pay more than the face value or par value of the bond. Why would they do that? Well, if overall interest rates have dropped, then bonds with coupon rates paying higher interest levels will be bid up. When this happens, your bond can be bid up to be selling above par.
Example: Galactic Empire incorporates and decides to issue bonds because they're in debt after building a new space station. Darth Vader decides he wants to buy a $1,000 bond. He's getting up there in years and wants to be able to enjoy his days in retirement at some point. He gets himself a 5-year bond with a 10% coupon. That means that, every year, he'll get $100 for handing over his cash, and at the end of five years, he’ll get his original $1,000 back. After two years, Darth is dreaming about what he'll do with that money if there's a disturbance in the Force. Interest rates drop. Now the same type of bond from the Empire comes with a 6% coupon because of the change. Good ol' Darth is feeling pretty smug because his bond 10% interest or $100 a year is locked in, but what happens to anyone who wants to invest now?
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Finance: What is a Muni Bond?24 Views
finance a la shmoop. what is a muni bond? all right well this is a moonie bond or
band as they say in America. all right and this is a muni bond or municipal [people in orange robes sing together]
bond. yeah that muni thing there is for short.
well muni bonds function differently from the way in which normal corporate
bonds function in America. municipal bonds are financing that cities do to
raise money. think local think townhall meetings like old folks arguing about
where to install new speedbumps. think angry local residents berating their
federal senators .though this stuff might sound like small change local government
is the backbone of the US of A. without your lovely local government you
wouldn't have sewer systems,or local roads, or that one Park you and your
friends hang out at when you're up to no good. yeah we know we've seen you on the
video camera. alright so muni bonds are a must-have in [pictures of people in parks]
society ,not a nice-to-have. and as a result we treat them specially.
that is we don't tax the interest they throw off and that's a big deal. a
corporate bond yielding 7% to investors who pay 40% tax gives investors a net
yield after taxes of 1 minus point for their times seven equals four point two
percent. well a muni bond can pay just four point three percent - ie slightly
more net than a corporate bond with the same risk and be a good deal for its
buyers. that difference of two point seven percent in interest is a huge
difference over time in the cost of capital from municipalities already
strapped for cash trying to raise money desperate to get that new sewer system [equation showing bond return rates]
in place for well you know a whole variety of reasons. and you know use that
rule of seventy two thing you here remember you divide the 2.7 and 72 ,yah
that's how many years it takes to double, okay, but what happens when a Muni can't
pay its bills, well in corporate America the bondholders just take possession of
the company operate it with new management pay off the debts they're
owed and well then sell it more or less. but with muni bonds you can't just
auction off a sewage treatment plant or a Reservoir Dam on
eBay. they'd sell it a huge discount for what money went into him like well maybe [ebay listing shown]
you sell them to a golf course developer or well maybe they just don't sell it
all there are zero residual value and yes
ouch. so muni bonds get treated with a little bit different perspective on risk
like the city is on the hook for them in different ways, and there are two basic
flavors of muni bonds as far as they're being backed. there's general obligation
bonds which are bonds backed by The Full Faith and Credit of the city, and then
there are revenue bonds backed only by sales expected to be reaped from a
specific project, say you know that new 8 story parking structure in the middle of
town which charges you 40 bucks a day to park your car.
well that 40 bucks or at least part of it would go back to repay the owners of [parking garage pictured]
the revenue bond. so why wouldn't you knee bones be backed in two different
ways? well because investors like to know what happens if the city doesn't pay
back its bills. general obligation bonds are backed by the city's ability to tax
its citizens. that's that under Full Faith and Credit thing. that is the
general obligation bonds oblige- see that's that obligation thing- they oblige
the entire city generally to pay its bills. like even if they have to double
tax the rich people in the city hoping they don't move out you know pay back
the money they borrowed. if a city ever renigs well they'll lose that Full Faith
and Credit from investors, and well good luck ever raising money again, or at
least certainly at any kind of favorable rates. with revenue bonds the backing is
narrower, the project is riskier, and usually the interest rates that come [types of muni bonds]
with it are higher. payment on these bonds comes from the revenue generated
from what the bonds were used to create. right like bonds to build a toll road or
another example here. thought it may be better than the parking authority thing
yeah okay okay. all right well the issuer can estimate fairly accurately the
revenue that will be generated from those tolls and then it's up to the [equation pictured]
investor to decide if that revenue will be sufficient enough to service the debt
on the bond. and historically muni bonds are very safe .only a handful of muni
offerings in the US have ever not paid back everything .so in the scheme of
things munis are a good risk. at least they have been as Illinois in
California begin to Teeter on the edges of bankruptcy it'll be interesting to
see what happens to the creditworthiness of their big cities, and whether they
manage to climb back up to steady ground or enjoy a nice skydive you know - the
parachute. either way Muni balance will remain one of the most
fundamental financial institutions of the US of A while a mooning bond well
that'll have to remain a personal fantasy. yes sounds look double o heaven. [person moons camera]
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