State and local governments have long relied on bond financing to pay for capital projects such as schools, highways, civic buildings, and recreational and cultural amenities. For most communities, it’s not practicable to fund multimillion-dollar projects from monthly cash flow, said David Unmacht, executive director of the League of Minnesota Cities. “These are large capital investments that are spread out over a long period, in some cases 25 or 50 years; it makes sense to borrow over the expectant life of the project to pay that bill.”
When a government entity issues bonds, it promises to pay investors interest and return the principal on a specified maturity date. Muni bonds have terms of anywhere from one to 30 years; the longer the term, the higher the interest rate to compensate investors for greater credit and inflation risk.
Municipal securities offer investors such as banks, insurers and individuals modest returns and the safety of a government payer. Bond defaults are very rare, although issuers with less than sterling credit ratings from agencies such as Moody’s Investors Service and Standard & Poor’s pay higher interest rates. Most munis have the added attraction of being tax-exempt; investors don’t pay federal taxes on interest income, and in most states bonds issued in that state are also exempt from state and local taxes.
Municipal bonds fall into two major categories. General obligation (G.O.) bonds are considered more secure because the issuer pledges to levy property, sales or other general taxes to honor the bonds. Revenue bonds are usually repaid from nontax sources, such as fee revenue generated from the project (a new sewer system, for example) being financed. Unlike G.O. bonds, revenue bonds don’t require direct taxpayer approval.
An issuer may opt to refund bonds—refinance outstanding bonds with the proceeds from a new debt issue—for a number of reasons, but mainly to take advantage of a drop in interest rates.
State-sanctioned authorities may issue bonds on behalf of not-for-profit organizations for low-income housing, health care facilities, airport expansion and other projects not considered core government functions. Last year, the South Dakota Health and Educational Facilities Authority issued $100 million in bonds to help Sanford Health, a large medical provider based in Sioux Falls, S.D., to build a genomic medicine center in that city and complete construction of a large new hospital in Fargo, N.D.