A government bond is a bond issued by a national government, generally with a promise to pay periodic interest payments and to repay the face value on the maturity date. Government bonds are usually denominated in the country’s own currency. Another term similar to government bond is “sovereign bond”. Technically any bond issued by a sovereign entity is a sovereign bond but sometimes the term is used to refer to bonds issued in a currency other than the sovereign’s currency. If a government or sovereign is close to default on its debt the media often refer to this as a sovereign debt crisis.
The terms on which a government can sell bonds depend on how creditworthy the market considers it to be. International credit rating agencies will provide ratings for the bonds, but ratings are not insurance against default.
Government bonds in a country’s own currency are sometimes taken as an approximation of the theoretical risk-free bond, because it is assumed that the government can raise taxes or create additional currency in order to redeem the bond at maturity. There have been instances where a government has defaulted on its domestic currency debt.
Currency risk is the risk that the value of the currency a bond pays out will decline compared to the holder’s reference currency. For example, a German investor would consider United States bonds to have more currency risk than German bonds (since the dollar may go down relative to the euro); similarly, a United States investor would consider German bonds to have more currency risk than United States bonds (since the euro may go down relative to the dollar).
Inflation risk is the risk that the value of the currency a bond pays out will decline over time. Investors expect some amount of inflation, so the risk is that the inflation rate will be higher than expected. Many governments issue inflation-indexed bonds, which protect investors against inflation risk by linking both interest payments and maturity payments to a consumer prices index
Types of tax-exempt bonds
Municipal bonds provide tax exemption from federal taxes and many state and local taxes, depending on the laws of each state. Municipal securities consist of both short-term issues (often called notes, which typically mature in one year or less) and long-term issues (commonly known as bonds, which mature in more than one year). Short-term notes are used by an issuer to raise money for a variety of reasons: in anticipation of future revenues such as taxes, state or federal aid payments, and future bond issuances; to cover irregular cash flows; meet unanticipated deficits; and raise immediate capital for projects until long-term financing can be arranged. Bonds are usually sold to finance capital projects over the longer term.
The two basic types of municipal bonds are:
- General obligation bonds: Principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer’s unlimited or limited taxing power. In many cases, general obligation bonds are voter-approved.
- Revenue bonds: Principal and interest are secured by revenues derived from tolls, charges or rents from the facility built with the proceeds of the bond issue. Public projects financed by revenue bonds include toll roads, bridges, airports, water and sewage treatment facilities, hospitals and subsidized housing. Many of these bonds are issued by special authorities created for that particular purpose.
Most municipal notes and bonds are issued in minimum denominations of $5,000 or multiples of $5,000.
Purpose of municipal bonds
Municipal bonds are securities that are issued for the purpose of financing the infrastructure needs of the issuing municipality. These needs vary greatly but can include schools, streets and highways, bridges, hospitals, public housing, sewer, water systems, power utilities, and various public projects.
Municipal bonds are issued by states, cities, and counties, (the municipal issuer) to raise funds. The methods and traces of issuing debt are governed by an extensive system of laws and regulations, which vary by state. Bonds bear interest at either a fixed or variable rate of interest, which can be subject to a cap known as the maximum legal limit. If a bond measure is proposed in a local county election, a Tax Rate Statement may be provided to voters, detailing best estimates of the tax rate required to levy and fund the bond.Municipal bond issuers.
The issuer of a municipal bond receives a cash payment at the time of issuance in exchange for a promise to repay the investors who provide the cash payment (the bond holder) over time. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer.
The issuer typically uses proceeds from a bond sale to pay for capital projects or for other purposes it cannot or does not desire to pay for immediately with funds on hand. Tax regulations governing municipal bonds generally require all money raised by a bond sale to be spent on one-time capital projects within three to five years of issuance. Certain exceptions permit the issuance of bonds to fund other items, including ongoing operations and maintenance expenses, the purchase of single-family and multi-family mortgages, and the funding of student loans, among many other things.
Because of the special tax-exempt status of most municipal bonds, investors usually accept lower interest payments than on other types of borrowing (assuming comparable risk). This makes the issuance of bonds an attractive source of financing to many municipal entities, as the borrowing rate available in the open market is frequently lower than what is available through other borrowing channels.
Municipal bonds are one of several ways states, cities and counties can issue debt. Other mechanisms include certificates of participation and lease-buyback agreements. While these methods of borrowing differ in legal structure, they are similar to the municipal bonds described in this article.
Municipal bond holders
Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an upfront investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself (see bond).
Repayment schedules differ with the type of bond issued. Municipal bonds typically pay interest semi-annually. Shorter term bonds generally pay interest only until maturity; longer term bonds generally are amortized through annual principal payments. Longer and shorter term bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, known as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.
A bond measure is an initiative to sell bonds for the purpose of acquiring funds for various public works projects, such as research, transportation infrastructure improvements, and others. These measures are put up for a vote in general elections and must be approved by a plurality or majority of voters, depending on the specific project in question.
Such measures are very often used in the United States when other revenue sources, such as taxes, are limited or non-existent.
Characteristics of municipal bonds
One of the primary reasons municipal bonds are considered separately from other types of bonds is their special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt from all federal taxes, as well as state or local taxes depending on the state in which the issuer is located, subject to certain restrictions. Bonds issued for certain purposes are subject to the alternative minimum tax.
The type of project or projects that are funded by a bond affects the taxability of income received on the bonds held by bond holders. Interest earnings on bonds that fund projects that are constructed for the public good are generally exempt from federal income tax, while interest earnings on bonds issued to fund projects partly or wholly benefiting only private parties, sometimes referred to as private activity bonds, may be subject to federal income tax. However, qualified private activity bonds, whether issued by a governmental unit or private entity, are exempt from federal taxes because the bonds are financing services or facilities that, while meeting the private activity tests, are needed by a government.
Purchasers of municipal bonds should be aware that not all municipal bonds are tax-exempt, and not all tax-exempt bonds are exempt from all federal and state taxes. The laws governing the taxability of municipal bond income are complex. At the federal level they are contained in the IRS Code, (Sections 103, 141-150), and rules promulgated thereunder. Each state will have its own laws governing what bonds, if any, are exempt from state taxes. For publicly offered bonds and most private placements, at the time of issuance a legal opinion will be provided indicating that the bonds are tax-exempt. Offering documents, such as an official statement or placement memorandum, will contain further information regarding tax treatment of interest on the bonds. Investors should be aware that there are also post-issuance compliance requirements that must be met to ensure that the bonds remain tax-exempt.
The IRS has a specific section of their website, www.irs.gov, devoted to tax exempt bonds and compliance with federal requirements.
A municipal bond is a bond issued by a local government, or their agencies. The term municipal bond is commonly used in the United States, which has the largest market of such trade-able securities in the world estimated at $3.7 Trillion in 2011. Potential issuers of municipal bonds include states, cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) at or below the state level. Municipal bonds may be general obligations of the issuer or secured by specified revenues.
Many other countries in the world also issue municipal bonds, sometimes called local authority bonds or other names. The key defining feature of this type of bond is that it is issued by a public-use entity at a lower level of government than the sovereign. A default of the local bond should not automatically trigger a default on the sovereign bonds. This article exclusively covers municipal bonds issued in U.S. dollars in the 50 states, Puerto Rico and U.S. territories. The U.S. municipal bond market is unique in the world for its size, liquidity, legal and tax structure and bankruptcy protection afforded by the U.S. Constitution.
In the United States, interest income received by holders of municipal bonds is often exempt from the federal income tax, and may be exempt from state income tax, although municipal bonds issued for certain purposes may not be tax exempt.
Unlike new issue stocks that are brought to market with price restrictions until the deal is sold, municipal bonds are free to trade at any time once they are purchased by the investor. Professional traders regularly trade and re-trade the same bonds several times a week. A feature of this market is a larger proportion of smaller retail investors compared to other sectors of the U.S. securities markets.
The risk (“security”) of a municipal bond is a measure of how likely the issuer is to make all payments, on time and in full, as promised in the agreement between the issuer and bond holder (the “bond documents”). Different types of bonds are secured by various types of repayment sources, based on the promises made in the bond documents:
- General obligation bonds promise to repay based on the full faith and credit of the issuer; these bonds are typically considered the most secure type of municipal bond, and therefore carry the lowest interest rate.
- Revenue bonds promise repayment from a specified stream of future income, such as income generated by a water utility from payments by customers.
- Assessment bonds promise repayment based on property tax assessments of properties located within the issuer’s boundaries.
In addition, there are several other types of municipal bonds with different promises of security.
The probability of repayment as promised is often determined by an independent reviewer, or “rating agency”. The three main rating agencies for municipal bonds in the United States are Standard & Poor’s, Moody’s, and Fitch. These agencies can be hired by the issuer to assign a bond rating, which is valuable information to potential bond holders that helps sell bonds on the primary market.
Municipal bonds have traditionally had very low rates of default as they are backed either by revenue from public utilities (revenue bonds), or state and local government power to tax (general obligation bonds). However, sharp drops in property valuations resulting from the 2009 mortgage crisis have led to strained state and local finances, potentially leading to municipal defaults.
To compensate for having additional value through the option to convert the bond to stock, a convertible bond typically has a coupon rate lower than that of similar, non-convertible debt. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity. From the issuer’s perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment.
The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies’ debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder’s equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.
Types of Convertible Bonds
Straight convertible bonds are the most plain convertible structures. They grant the holder the right to convert into certain amount of shares determined according to a conversion price determined in advance. They may offer coupon regular payments during the life of the security and have a fixed maturity date where the nominal value of the bond is redeemable by the holder. This type is the most common convertible type: at maturity the holder would either convert into shares or request the redemption at par depending on whether or not the stock price is above the conversion price.
Mandatory convertibles are a common variation. A mandatory convertible would force the holder to convert into shares at maturity – hence the term “Mandatory”. These securities very often bear two conversion prices, making their profiles similar to a “risk reversal” option strategy. The first conversion price would limit the price where the investor would receive the equivalent of its par value back in shares, the second would delimit where the investor will earn more than par. Note that if the stock price is below the first conversion price the investor would suffer a capital loss compared to its original investment (excluding the potential coupon payments).
Reverse convertibles are a less common variation, mostly issued synthetically. They would be opposite of the straight structure: the conversion price would act as a knock-in short call option: as the stock price drops below the conversion price the investor would start to be exposed the underlying stock performance and no longer able to redeem at par its bond. This negative convexity would be compensated by a usually high regular coupon payment
Additional features of Convertible Bonds
Any convertible bond structure, on top of its type, would bear a certain range of additional features as defined in its issuance prospectus:
- Conversion price: The nominal price per share at which conversion takes place, this number is fixed at the issuance but could be adjusted under some circumstance described in the issuance prospectus (e.g. Underlying stock split).
- Issuance premium: Difference between the conversion price and the stock price at the issuance.
- Conversion ratio: The number of shares each convertible bond converts into. It may be expressed per bond or on a per centum (per 100) basis.
Maturity/redemption date: Final payment date of a loan or other financial instrument, at which point the principal (and all remaining interest) is due to be paid. In some cases, there is no maturity date (i.e. perpetual), this is often the case with preferred convertibles.
- Final conversion date: Final date at which the holder can request the conversion into shares. Might be different from the redemption date.
Coupon: Periodic interest payment paid to the convertible bond holder from the issuer. Could be fixed or variable or equal to zero.
- Yield: Yield of the convertible bond at the issuance date, could be different from the coupon value if the bond is offering a premium redemption. In those cases the yield value would determine the premium redeption value and intermediary put redemption value.