NEW YORK — When Detroit became the biggest city in U.S. 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 an array of 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 city uses to keep itself running, but it can be tough to cut through the jargon and heated claims surrounding Detroit's bankruptcy. To help, here's a look at the nuts and bolts of what finance types call munis: who owns them, how they work and just what they are, anyway.
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. A fire district might need a few hundred thousand dollars for a new truck; a state might need a few billion to build highways and hospitals.
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. That could be one year later or as many as three decades later.
Have local governments borrowed a lot?
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 U.S. bond market. Corporations have borrowed more money, owing $5.9 trillion to bondholders. And the federal government has more publicly traded debt than both groups put together: $11.9 trillion.
For the sake of comparison, the value of the entire U.S. stock market is $18.7 trillion, according to S&P Dow Jones Indices.
What's the appeal?
It's mainly the tax-free income. The federal government taxes interest payments from savings accounts, corporate bonds and other investments, but doesn't touch income from muni bonds. To somebody in the top tax bracket, a New York State bond paying 3 percent is equal to a corporate bond paying 4.97 percent.
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.
"Tax-free bonds have been the best game in town for people who are well off and don't want to pay taxes," said Mark Schwartz, a former bond lawyer and investment banker who has a law practice in Bryn Mawr, Pa.
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 the prices may vary.
"You can call up five dealers and get five different prices," said Daniel Berger, senior market strategist at Thomson Reuters, "although the prices would be closer than you think."