Add-On Interest

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]