ShmoopTube

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finance a la shmoop. what is a muni bond? all right well this is a moonie bond or

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band as they say in America. all right and this is a muni bond or municipal [people in orange robes sing together]

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bond. yeah that muni thing there is for short.

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well muni bonds function differently from the way in which normal corporate

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bonds function in America. municipal bonds are financing that cities do to

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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difference over time in the cost of capital from municipalities already

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

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

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

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

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

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

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

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auction off a sewage treatment plant or a Reservoir Dam on

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

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

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all there are zero residual value and yes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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