Municipal Debt Explained: Types, Risks, and Tax Benefits

Municipal debt is a type of borrowing that allows cities, states, and other local governments to finance public projects and services. It's often used for infrastructure development, such as building roads, schools, and hospitals.

There are several types of municipal debt, including general obligation bonds, revenue bonds, and certificates of participation. General obligation bonds are backed by the full faith and credit of the issuer, while revenue bonds are secured by a specific source of income.

The tax benefits of municipal debt are a major draw for investors. For example, interest earned on municipal bonds is exempt from federal income tax, which can result in significant savings for investors.

Municipal debt is a way for local governments to borrow money to finance large capital assets, such as infrastructure and buildings, by issuing debt that can be repaid through tax revenues or special assessments.

Local governments can also use short-term debt to cover temporary cash flow deficits or finance projects until long-term borrowing is secured.

Long-term debt allows governments to acquire or build capital assets sooner by borrowing up front, but it increases the total cost of the asset through interest payments.

Issuing debt can be a useful tool for local governments to smooth out their expenses and create a more predictable cash flow by spreading out debt payments over many years.

The amount of debt a government can incur is limited by state and federal laws, including the Washington State Constitution and federal rules about the tax status of government securities.

There are three distinct types of debt that can be issued by local government: General Obligation (GO) debt, Revenue debt, and Special Assessment debt.

General Obligation debt is secured by the full faith and credit of the local government issuing the debt, with the municipality pledging its tax revenues unconditionally to pay the interest and principal on the debt as it matures.

Revenue debt is different from GO debt, relying on specific revenues generated by the issuer, such as water bills or tolls, to guarantee repayment.

Special Assessment debt is repaid from assessments against those who directly benefit from the project the funds have been used to finance, such as road improvements.

Revenue bonds are issued by government entities and are secured by revenues from a certain government project, such as tolls or taxes.

Revenue bonds are generally used to finance projects for self-supporting enterprises, like water and wastewater projects, airports, and stormwater systems.

Revenue bonds are not backed by the full faith and credit of the city, making them less secure than general obligation bonds.

The interest rate on revenue bonds may be higher than those on general obligation bonds due to the perceived risk.

Revenue bonds are not subject to statutory or constitutional debt limits, but the bond market provides an effective limit to the amount of bonds and/or debt issued.

Here are the three main types of municipal debt:

Long-term municipal debt can be a complex topic, but let's break it down. Long-term debt is a legal obligation that typically doesn't mature for more than a decade and often has a maturity date of 30-40 years, depending on the debt type.

There are different types of debt that can be issued by local government, including general obligation, revenue, and special assessment debt. General obligation debt is secured by the full faith and credit of the local government, while revenue debt is guaranteed by specific revenues generated by the issuer.

Long-term debt can be used to finance various capital projects, and the funding mechanism can vary widely depending on the project. Municipal bonds, which are a type of long-term debt, are available in a variety of terms ranging from two to 30 years.

Here's a breakdown of the different debt types and their characteristics:

In summary, long-term municipal debt can be used to finance various capital projects, and the funding mechanism can vary widely depending on the project.

General Obligation Bonds are secured by a pledge of the taxing district's property tax authority. They're often used for capital projects like land acquisition, park development, and transportation projects owned and operated by government.

There are two basic kinds of General Obligation Bonds: Limited Tax General Obligation (LTGO) and Unlimited Tax General Obligation (UTGO). LTGO bonds can be issued by a vote of the legislative body, but they don't provide any additional revenue to fund debt service payments. Instead, they must be paid from existing revenue sources.

UTGO bonds, on the other hand, must be approved by 60% of the voters, with a voter turnout equal to at least 40% of those who voted in the most recent general election. When voters approve UTGO bonds, they're also asked to approve an excess levy to cover debt service payments.

Here's a breakdown of the key differences between LTGO and UTGO bonds:

General Obligation Bonds have the backing of the "full faith and credit" of the issuer, which has the power to tax residents to pay bondholders. This makes them a relatively safe investment, as they're secured by the issuer's taxing power.

Revenue bonds are a type of municipal debt that's used to finance specific projects, such as water and wastewater systems, airports, and stormwater systems. These bonds are paid off through user fees generated by the capital facility being built.

The local entity is responsible for establishing and collecting sufficient revenue, usually through rates, to retire the debt. This means that revenue bonds are not backed by the full faith and credit of the city, making them less secure than general obligation bonds.

Revenue bonds are not subject to statutory or constitutional debt limits, but the bond market provides an effective limit to the amount of bonds and/or debt issued. Investors will only purchase bonds if they believe the project will generate enough revenue to make the bond payments.

Revenue bonds can be secured by revenues from a certain government project, such as tolls or taxes. However, the bonds' yields can fluctuate depending on the amount of revenue collected from the sources.

Revenue bonds are generally used to finance projects that can generate a steady stream of revenue, such as water and wastewater systems. They're often used for projects that have a clear source of funding, like airports or stormwater systems.

Revenue bonds can be non-recourse, meaning that if the revenue stream dries up, the bondholders don't have a claim on the underlying revenue source. This can make them riskier than general obligation bonds.

Here's a breakdown of the key characteristics of revenue bonds:

Local governments have options beyond traditional borrowing methods to acquire property with tax-exempt financing.

Lease-purchase agreements allow governments to make installment payments over time, with the option to acquire the property at the end of the lease period for a nominal payment. This can be a more flexible option than traditional financing.

Conditional sales contracts involve the vendor providing financing, reserving the right to repossess the property if the government defaults. The vendor may assign these rights to a bank at some point during the contract.

Certificates of participation (COPs) can transform a lease or conditional sales contract into a marketable security, allowing investors to purchase shares in the lease. This is often used for smaller equipment purchases that wouldn't warrant the cost of issuing a bond.

Private activity bonds are tax-exempt revenue bonds often issued by public development corporations to finance non-governmental activities that satisfy a substantial public purpose.

These bonds are used to facilitate economic and industrial development, increase employment, and finance housing, making them a valuable tool for private businesses and public development corporations.

In Washington State, private businesses typically work with a state or local bond issuer to issue these bonds. The bond issuer then applies to the Department of Commerce for authorization.

The Department of Commerce is responsible for evaluating projects, authorizing bond issuances, and ensuring the state does not exceed its cap authority permitted under federal law.

Improvement Districts can be formed to fund projects that benefit a specific group of people, like street improvements or water systems.

Property owners can petition their local government to create an Improvement District, or the government can take the initiative.

An assessment roll is created, with each property's assessment based on the estimated special benefit to that property.

Property owners can pay their assessments upfront, but often Improvement District bonds are issued to cover part of the project cost.

LID bonds are not general obligations and are not backed by the city's full faith and credit.

ULIDs, on the other hand, require revenue bonds to be issued, and assessments must be deposited into a fund to pay off the bonds.

ULIDs are backed by both assessments and utility revenue.

Conduit bonds are a type of financing arrangement where a third-party entity issues bonds on behalf of the actual borrower, often a private nonprofit entity.

These bonds are typically issued by conduit borrowers, such as nonprofit colleges and hospitals, which agree to repay the issuer, who then pays the interest and principal on the conduit bonds.

However, if the conduit borrower fails to make a payment, the issuer is usually under no obligation to pay the bondholder, leaving them without a return on their investment.

The issuance of conduit bonds can be a risk for investors, as they may not receive the expected return on their investment.

Alternative Financing Arrangements can be a game-changer for local government entities looking to acquire property with tax-exempt financing.

Lease-purchase agreements allow local governments to make installment payments to a vendor or third-party investor over time, with the option to acquire the property at the end of the lease period for a nominal payment.

These agreements are often used for acquiring real or personal property, and can provide a flexible alternative to traditional financing methods.

Conditional sales contracts, on the other hand, involve the vendor providing financing, while reserving the right to repossess the property if the local government defaults.

This type of contract is often used in conjunction with lease-purchase agreements, and can provide an added layer of security for both parties involved.

Certificates of participation (COPs) transform leases or conditional sales contracts into marketable securities, allowing investors to purchase shares in the lease.

This can be a cost-effective way to finance purchases of equipment, particularly for smaller jurisdictions that may not have the resources to issue bonds individually.

The LOCAL program of the Office of the State Treasurer is a great example of how COPs can be used to aggregate small purchases into a single bond, resulting in volume savings on issuance costs.

Lines of credit offer a flexible financing option for local governments. A bank and city agree on a maximum amount available under the line of credit, which is backed by the full faith and credit of the jurisdiction.

This arrangement provides a more stable alternative to anticipation notes. The local government provides a note to the bank, which allows them to draw on the credit line as needed.

The amount of outstanding principal drawn against a line of credit counts against the debt limits. This is an important consideration for local governments looking to manage their finances effectively.

Investing in municipal debt can be a safe and attractive option for investors. Most municipal bonds are issued in $5,000 increments, but some exchange-traded funds (ETFs) and mutual funds allow investors to purchase bond fractions.

Municipal bonds are generally safe, but there is some variance. A small municipality with a large amount of debt is less safe than a well-capitalized state like Wyoming. In general, they are approximately as safe as corporate bonds, but not as safe as U.S. Government Debt.

Investors can benefit from municipal bonds in several ways. They offer a steady income stream, have a relatively low rate of default, and are exempt from federal taxes. In fact, the default rate on investment-grade munis is only 0.09% between 1970 and 2022, compared to 2.25% for investment-grade corporate bonds.

Here are some key facts to consider when evaluating a municipal bond:

Investing in municipal debt is a smart move, especially considering the safety and stability it offers. With a default rate of just 0.09% on investment-grade munis between 1970 and 2022, you can rest assured that your investment is secure.

Munis are also a great way to reduce your tax liability. You pay no federal taxes and sometimes no state taxes, making them an attractive option for those looking to minimize their tax burden.

One of the biggest benefits of munis is their low default rate compared to corporate bonds. In fact, investment-grade munis have a default rate of 0.09% compared to 2.25% for corporate bonds over the same period.

Here are some key facts to keep in mind when considering a muni investment:

Lower interest rates from the Federal Reserve can also lead to higher prices on munis, resulting in positive total returns for investors. In fact, munis have delivered positive 12-month total returns in five of the last seven rate-cutting cycles.

Mutual fund holdings of municipal securities account for almost a third of municipal securities outstanding.

In the first two months of 2020, mutual funds investing in municipal securities received inflows totaling $22 billion, continuing a trend of record inflows experienced throughout 2019, when total inflows leapt to $90 billion.

Outflows from municipal bond mutual funds reversed suddenly in March, with $43 billion of outflows.

This was a significant shift from the record inflows experienced just a few months prior, and it had a noticeable impact on the market.

Municipal bond mutual funds experienced outflows of $43 billion in March, resulting in almost no demand for new issuance at the peak of the market disruption.

Outflows slowed down markedly in April, and municipal bond mutual funds have received net inflows each week since the first week of May.

Municipal debt is a type of debt issued by local governments to finance public projects. There are three distinct types of debt: general obligation (GO) debt, revenue debt, and special assessment debt.

General obligation debt is secured by the full faith and credit of the local government, meaning the municipality pledges its tax revenues unconditionally to pay the interest and principal on the debt as it matures.

Revenue debt, on the other hand, is guaranteed by the specific revenues generated by the issuer. For example, water districts can issue revenue debt with the revenues from customer water bills guaranteeing the repayment of the debt.

Special assessment debt is repaid from assessments against those who directly benefit from the project the funds have been used to finance.

Here's a breakdown of the three types of municipal debt:

Understanding the type of debt issued is crucial when evaluating municipal debt. It's essential to consider the specific characteristics of each type to make informed investment decisions.

Investors can benefit from municipal debt, especially if they're in a high income bracket. In a favorable financial environment, municipal bonds can offer attractive yields, including tax-free income.