There are two common types of municipal bonds:
- General obligation bonds, also known as GOs, are issued by states, cities or counties. They are backed by the "full faith and credit" of the government entity issuing the bonds. This backing is only as strong as the entity's ability to levy taxes on its citizens, and in some cases charge user or assessment fees. The creditworthiness of GOs is based primarily on the economic vitality of the issuer's tax base. Highly-rated GOs tend to have a strong tax base.
- Revenue Bonds are backed solely by fees or other revenue generated or collected by a facility, such as tolls from a bridge or road, or leasing fees. The creditworthiness of revenue bonds tends to rest on a debt service coverage ratio—the relationship between revenue coming in and the cost of paying interest on the debt. Highly-rated revenue bonds usually have a debt service ratio of two or more (the revenue that comes in is twice as much as the cost of paying interest on the debt).
| Investor Warning: Unrated and low-rated muni bonds exist and are actively sold, and defaults occur. You should carefully weigh the significant risk of investing in highly speculative securities. While the absence of a credit rating is not, by itself, a determinant of low credit quality, investors in non-rated bonds should be prepared to make their own independent credit analysis of the bonds. If you are unable to do so, then ask yourself if losing your investment is worth the higher coupon rate these bonds may carry.
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In addition to the general muni bond categories above, you can buy muni bonds with special features. For example, a muni can come with insurance. Insured munis are backed by municipal bond insurance specifically designed to reduce investment risk. In the event of default, an insurance company that guarantees payment will send you both interest and principal when they are due. You should keep in mind that such guarantees are only as valuable as the creditworthiness of the third party making the guarantee or providing the insurance. Insured munis tend to pay a lower coupon rate than those not offering insurance.
Anticipation notes are short-term notes that are used by states and cities to meet a short-term financing need. They usually mature in less than a year and are generally issued at par and pay interest at maturity.
Other types of munis are floating-rate and variable-rate muni bonds. These bonds are extremely short-term investments that are issued with 7-day and 28-day put features, allowing the investor to "put" the bond back to the issuer or issuer agent. Generally, the bond's interest rate is recalculated on the "put" date based upon a percentage of prevailing rates for Treasury bills or other interest rates.
There are also municipal securities, including zero-coupon munis, that are structured to give investors a lump-sum payment at maturity that is equivalent to the principal invested, but have no regular interest payments. These bonds are issued at a deep discount to the maturity. This type of muni is often used to save for a specific event, such as college education, but because they do not pay interest until maturity, their prices can be volatile.
Like most other securities, munis can have call provisions. It has been estimated by Thompson Financial that more than 75% of municipal bonds sold to investors in 2004 have call features allowing them to be redeemed early.
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