How do municipal bonds work?

NEW YORK — When Detroit became the biggest city in US history to file for bankruptcy last month, it turned public attention to the municipal-bond market, where cities and states go to borrow money. Was this sleepy, often-overlooked area of the financial world actually dangerous?

Like other cities, Detroit borrowed from investors to pay for roads, sewer lines, and other projects. Now Detroit says it can’t afford to pay bond investors all of their money back.

Even if you don’t own any muni bonds, it’s important to understand what they are and how they work. They’re what your community uses to keep itself running. To help, here’s a look at the nuts and bolts of what finance types call munis.

What are municipal bonds, exactly?


Cities, states, towns, and other local governments sell municipal bonds to raise money for school renovations, sports stadiums, or other projects. When investors buy a muni bond, they’re lending to a local government. In return, they get a regular interest payment and the promise of all their money back at the end of the bond’s life.

Have local governments borrowed a lot?

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The total amount of municipal debt outstanding is $3.72 trillion, according to the Federal Reserve’s latest report. That may sound enormous, but it’s less than a fifth of the total $21.7 trillion US bond market. Corporations have borrowed more money, owing $5.9 trillion to bondholders. And the US government: $11.9 trillion.

What’s the appeal?

It’s mainly the tax-free income.

Who owns them?

They’re mainly held by individuals, who buy them outright or through mutual funds. Individuals hold 44 percent of all munis, and mutual funds have another 25 percent, according to the Fed. Banks and insurance companies own much of the rest. Buying municipal bonds directly tends to be the province of wealthy people who have the most to gain from the tax exemption.

How can I buy them?

You can usually buy munis through your online brokerage account, but it’s not exactly like buying stocks. They’re traded ‘‘over the counter.’’ That means there is no formal, centralized exchange with one agreed-upon price for a security. Instead, you have to buy them through a dealer, and prices may vary.

What kind of return can you expect?


When there’s little risk, there’s little reward. Thanks to their solid credit history, municipalities pay very low rates to borrow money.

A type of muni called a ‘‘general obligation’’ bond is considered especially safe. They’re backed by a city’s full faith and credit, which essentially means a city will take extreme steps to repay them — even if it has to cut police and fire protection or raise taxes.

The average yield on a top-rated, 10-year general-obligation muni bond is 2.71 percent, Thomson Reuters says.

What’s going on in Detroit?

Detroit owes billions to bondholders and billions more in pensions to retired city workers. In its bankruptcy filing, the city proposed trimming pension benefits and paying bondholders a fraction of what they’re owed. It also wants to treat retired city workers and bond investors as equals.

Both groups plan to fight the city’s proposal. The retirees argue that Michigan’s state constitution protects their pensions. Investors who hold general-obligation bonds expect not only to rank first in the lineup of creditors but also to be paid in full. Laws often require local governments to pay bondholders before they pay anybody else.


Bond investors worry that if Detroit manages to pay them less than the full amount, it would set a precedent for other cities to follow.

Will it affect me?

Probably not, unless you worked for the city of Detroit or own its bonds.

How has the municipal market reacted to Detroit?

Interest rates on some bonds have crept up since the news broke, so some cities and towns will have to pay more to borrow from bond investors. Many investors, though, see Detroit as an isolated incident.