Column: Here’s a primer on municipal bonds

Municipal bonds have been in the local news quite often lately. With such a relevant topic that will remain a point of conversation for some time, several readers asked me to provide information on bonds.

It is not possible to completely explain every variation or nuance related to bonds within the scope of this column. What follows is a basic primer and I suggest that, if you have more interest in this topic, you should speak with your financial and tax advisers.

Stock is a form of ownership in a company. A stock may include rights to vote, receive dividends and even participate in the growth (or decline) of a company. Conversely, a bond is a loan (debt obligation) issued by a company, municipality, federal government, or other entity. In most situations, the person buying the bond expects to receive interest income and the eventual return of the money they “loaned” to the organization.

Municipal bonds are debt obligations issued by states, cities, counties, and other governmental entities which use the money to build roads, hospitals, sewer systems, and many other projects for the public good. This would include schools. Municipal bonds used for public purposes, such as the construction of highways or public schools, are usually free of federal income tax. The interest from municipal bonds is only exempt from state income tax in the state the bond is issued although there may be exceptions. For example: If you live in South Carolina and bought a municipal bond issued by the state of North Carolina, the interest earned on the bond would be taxable on your state (not federal) income tax return.

Schools bonds allow the school district to obtain funds in greater amounts and at a lower cost than traditional loan sources. While they use the initial invested amount for the building of schools and facilities, the schools will pay interest to the bond holders. At the end of the bond term, or if the bond is called early, the owners of their bonds will receive the par value of the bond.

Among the many factors one should consider before purchasing a municipal bond, one is the bonds rating. Bonds are rated on the basis of the credit worthiness of the issuer. In simple terms, that means that they are rated based upon the likelihood that the issuer will pay the interest and return the money they borrowed. Although there are other rating services, Moody’s is one commonly referred to when looking at the credit worthiness of a municipal bond. Ratings are listed as: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. Moody’s also adds a numerical modifier of one, two or three, indicating where the bond ranks within the rating group.

Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk. Obligations rated C are the lowest rated class of bonds and are typically in default, with little prospect for recovery of principal or interest.

In summary, municipal bonds issued by a school district will provide funding for the districts planned repairs and expansion. The interest they will pay will be received federal income tax free and may be state income tax free. The likelihood of receiving that interest and return of your invested funds will depend upon many factors, but Moody’s Investor Services offers a rating system that attempts to rate the likelihood that the school district will meet their financial obligations. If you would like to know more about purchasing Municipal Bonds, you should speak with your financial and tax advisors.

This story was originally published August 3, 2015 at 3:03 PM with the headline "Column: Here’s a primer on municipal bonds."