Money market

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In finance, the money market is the global financial market for short-term borrowing
and lending. It provides short-term liquidity funding for the global financial system. The
money market is where short-term obligations such as Treasury bills, commercial paper
and bankers' acceptances are bought and sold.

The money market consists of financial institutions and dealers in money or credit who
wish to either borrow or lend. Participants borrow and lend for short periods of time,
typically up to thirteen months. Money market trades in short-term financial instruments
commonly called "paper." This contrasts with the capital market for longer-term funding,
which is supplied by bonds and equity.

The core of the money market consists of banks borrowing and lending to each other,
using commercial paper, repurchase agreements and similar instruments. These
instruments are often benchmarked (to i.e. priced by reference to) the London Interbank
Offered Rate (LIBOR) for the appropriate term and currency.

Finance companies, such as GMAC, typically fund themselves by issuing large amounts
of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible
assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card
receivables, residential/commercial mortgage loans, mortgage-backed securities and
similar financial assets. Certain large corporations with strong credit ratings, such as
General Electric, issue commercial paper on their own credit. Other large corporations
arrange for banks to issue commercial paper on their behalf via commercial paper lines.

In the United States, federal, state and local governments all issue paper to meet funding
needs. States and local governments issue municipal paper, while the US Treasury issues
Treasury bills to fund the US public debt.

• Trading companies often purchase bankers' acceptances to be tendered for

payment to overseas suppliers.
• Retail and institutional money market funds
• Banks
• Central banks
• Cash management programs
• Arbitrage ABCP conduits, which seek to buy higher yielding paper, while
themselves selling cheaper paper.

Contents
[hide]

• 1 History
o 1.1 Development of the Money Market
• 2 Common money market instruments
• 3 See also

• 4 External links

[edit] History
[edit] Development of the Money Market
 Please help improve this article or section by expanding it. Further
information might be found on the talk page. (November 2008)

[edit] Common money market instruments

• Bankers' acceptance - A draft issued by a bank that will be accepted for payment,
effectively the same as a cashier's check.
• Certificate of deposit - A time deposit at a bank with a specific maturity date;
large-denomination certificates of deposits can be sold before maturity.
• Repurchase agreements - Short-term loans—normally for less than two weeks and
frequently for one day—arranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date.
• Commercial paper - Unsecured promissory notes with a fixed maturity of one to
270 days; usually sold at a discount from face value.
• Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch
located outside the United States.
• Federal Agency Short-Term Securities - (in the U.S.). Short-term securities issued
by government sponsored enterprises such as the Farm Credit System, the Federal
Home Loan Banks and the Federal National Mortgage Association.
• Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other
depository institutions at the Federal Reserve; these are immediately available
funds that institutions borrow or lend, usually on an overnight basis. They are lent
for the federal funds rate.
• Municipal notes - (in the U.S.). Short-term notes issued by municipalities in
anticipation of tax receipts or other revenues.
• Treasury bills - Short-term debt obligations of a national government that are
issued to mature in three to twelve months. For the U.S., see Treasury bills.
• Money market mutual funds - Pooled short maturity, high quality investments
which buy money market securities on behalf of retail or institutional investors.
• Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the
reversal of the exchange of currencies at a predetermined time in the future.

Treasury security
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The examples and perspective in this article may not represent a worldwide view of
the subject. Please improve this article or discuss the issue on the talk page.
This article needs additional citations for verification. Please help improve this
article by adding reliable references. Unsourced material may be challenged and
removed. (October 2008)
Treasury securities are government bonds issued by the United States Department of the
Treasury through the Bureau of the Public Debt. They are the debt financing instruments
of the U.S. Federal government, and they are often referred to simply as Treasuries or
Treasurys. There are four types of marketable treasury securities: Treasury bills,
Treasury notes, Treasury bonds, and Treasury Inflation Protected Securities (TIPS). There
are several types of non-marketable treasury securities including State and Local
Government Series (SLGS), Government Account Series debt issued to government-
managed trust funds, and savings bonds. All of the marketable Treasury securities are
very liquid and are heavily traded on the secondary market. The non-marketable
securities (such as savings bonds) are issued to subscribers and cannot be transferred
through market sales.

Contents
[hide]

• 1 Marketable Securities
o 1.1 Directly issued by the United States Government
 1.1.1 Treasury bill
 1.1.2 Treasury note
 1.1.3 Treasury bond
 1.1.4 TIPS
o 1.2 Created by the Financial Industry
 1.2.1 STRIPS
• 2 Nonmarketable Securities
o 2.1 Zero-Percent Certificate of Indebtedness
o 2.2 Government Account Series
o 2.3 U.S. Savings Bonds
 2.3.1 Series EE
 2.3.2 Series HH
 2.3.3 Series I
• 3 History
• 4 See also
• 5 References

• 6 External links

[edit] Marketable Securities

[edit] Directly issued by the United States Government

[edit] Treasury bill

Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do
not pay interest prior to maturity; instead they are sold at a discount of the par value to
create a positive yield to maturity. Many regard Treasury bills as the least risky
investment available to U.S. investors.

Regular weekly T-bills are commonly issued with maturity dates of 28 days (or 4 weeks,
about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6
months), and 364 days (or 52 weeks, about 1 year). Treasury bills are sold by single price
auctions held weekly. Offering amounts for 13-week and 26-week bills are announced
each Thursday for auction, usually at 1:00 pm, on the following Monday and settlement,
or issuance, on Thursday. Offering amounts for 4-week bills are announced on Monday
for auction the next day, Tuesday, usually at 1:00 pm, and issuance on Thursday. Offering
amounts for 52-week bills are announced every fourth Thursday for auction the next
Tuesday, usually at 1:00 pm, and issuance on Thursday. Purchase orders at
TreasuryDirect must be entered before 11:30 on the Monday of the auction. The
minimum purchase - effective April 7, 2008 - is $100. (This amount formerly had been
$1,000.) Mature T-bills are also redeemed on each Thursday. Banks and financial
institutions, especially primary dealers, are the largest purchasers of T-bills.

Like other securities, individual issues of T-bills are identified with a unique CUSIP
number. The 13-week bill issued three months after a 26-week bill is considered a re-
opening of the 26-week bill and is given the same CUSIP number. The 4-week bill issued
two months after that and maturing on the same day is also considered a re-opening of the
26-week bill and shares the same CUSIP number. For example, the 26-week bill issued
on March 22, 2007, and maturing on September 20, 2007, has the same CUSIP number
(912795A27) as the 13-week bill issued on June 21, 2007, and maturing on September
20, 2007, and as the 4-week bill issued on August 23, 2007 that matures on September
20, 2007.

During periods when Treasury cash balances are particularly low, the Treasury may sell
cash management bills (or CMBs). These are sold at a discount and by auction just like
weekly Treasury bills. They differ in that they are irregular in amount, term (often less
than 21 days), and day of the week for auction, issuance, and maturity. When CMBs
mature on the same day as a regular weekly bill, usually Thursday, they are said to be on-
cycle. The CMB is considered another reopening of the bill and has the same CUSIP.
When CMBs mature on any other day, they are off-cycle and have a different CUSIP
number.

Treasury bills are quoted for purchase and sale in the secondary market on an annualized
percentage yield to maturity, or basis.

With the advent of TreasuryDirect, individuals can now purchase T-Bills online and have
funds withdrawn from and deposited directly to their personal bank account and earn
higher interest rates on their savings.

General calculation for yield on Treasury bills is

[edit] Treasury note

Treasury notes (or T-Notes) mature in two to ten years. They have a coupon payment
every six months, and are commonly issued with maturities dates of 2, 3, 5 or 10 years,
for denominations from $100 to $1,000,000.

T-Notes and T-Bonds are quoted on the secondary market at percentage of par in thirty-
seconds of a point. Thus, for example, a quote of 95:07 on a note indicates that it is
trading at a discount: $952.19 (i.e. 95 7/32%) for a $1,000 bond. (Several different
notations may be used for bond price quotes. The example of 95 and 7/32 points may be
written as 95:07, or 95-07, or 95'07, or decimalized as 95.21875.) Other notation includes
a +, which indicates 1/64 points and a third digit may be specified to represent 1/256
points. Examples include 95:07+ which equates to (95 + 7/32 + 1/64) and 95:073 which
equates to (95 + 7/32 + 3/256). Notation such as 95:073+ is unusual and not typically
used.

The 10-year Treasury note has become the security most frequently quoted when
discussing the performance of the U.S. government-bond market and is used to convey
the market's take on longer-term macroeconomic expectations.

[edit] Treasury bond

"U.S. Bonds" redirects here. You may be looking for the singer Gary U.S. Bonds.

Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from ten years
to thirty years. They have a coupon payment every six months like T-Notes, and are
commonly issued with maturity of thirty years. The secondary market is highly liquid, so
the yield on the most recent T-Bond offering was commonly used as a proxy for long-
term interest rates in general.[citation needed] This role has largely been taken over by the 10-
year note, as the size and frequency of long-term bond issues declined significantly in the
1990s and early 2000s.[original research?]

The U.S. Federal government stopped issuing the well-known 30-year Treasury bonds
(often called long-bonds) for a four and a half year period starting October 31, 2001 and
concluding February 2006.[1] As the U.S. government used its budget surpluses to pay
down the Federal debt in the late 1990s, the 10-year Treasury note began to replace the
30-year Treasury bond as the general, most-followed metric of the U.S. bond market.
However, due to demand from pension funds and large, long-term institutional investors,
along with a need to diversify the Treasury's liabilities - and also because the flatter yield
curve meant that the opportunity cost of selling long-dated debt had dropped - the 30-year
Treasury bond was re-introduced in February 2006 and is now issued quarterly.[2] This
brought the U.S. in line with Japan and European governments issuing longer-dated
maturities amid growing global demand from pension funds.[citation needed] Some countries,
including France and the United Kingdom, have begun offering a 50-year bond, known
as a Methuselah.[citation needed]
[edit] TIPS

Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds

issued by the U.S. Treasury. These securities were first issued in 1997. The principal is
adjusted to the Consumer Price Index, the commonly used measure of inflation. The
coupon rate is constant, but generates a different amount of interest when multiplied by
the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are
currently offered in 5-year, 10-year and 20-year maturities. 30-year TIPS are no longer
offered.[3]

In addition to their value for a borrower who desires protection against inflation, TIPS
can also be a useful information source for policy makers: By comparing a TIPS bond
with a standard nominal Treasury bond across the same maturity dates, investors may
calculate the bond market's expected inflation rate by applying the Fisher equation.[citation
needed]

[edit] Created by the Financial Industry

[edit] STRIPS

Separate Trading of Registered Interest and Principal Securities (or STRIPS) are T-
Notes, T-Bonds and TIPS whose interest and principal portions of the security have been
separated, or "stripped"; these may then be sold separately (in units of $1000 face value)
in the secondary market. The name derives from the days before computerization, when
paper bonds were physically traded; traders would literally tear the interest coupons off of
paper securities for separate resale.

The government does not directly issue STRIPS; they are formed by investment banks or
brokerage firms, but the government does register STRIPS in its book-entry system. They
cannot be bought through TreasuryDirect, but only through a broker.

STRIPS are used by the Treasury and split into individual principal and interest
payments, which get resold in the form of zero-coupon bonds. Because they then pay no
interest, there isn't any interest to re-invest, and so there is no reinvestment risk with
STRIPS.

[edit] Nonmarketable Securities

[edit] Zero-Percent Certificate of Indebtedness

The "Certificate of Indebtedness" is a Treasury security that does not earn any interest
and has no fixed maturity. It can only be held in a TreasuryDirect account and bought or
sold directly through the Treasury. It is intended to be used as a source of funds for
traditional Treasury security purchases. Purchases and redemptions can be made at any
time.
[edit] Government Account Series

Government Account Series Treasuries are the principal form of intragovernmental debt
holdings.[4] Surpluses from the Social Security Trust Fund are invested in these type of
securities.[citation needed]

[edit] U.S. Savings Bonds

[edit] Series EE

Series EE bonds are issued at 50% of their face value and reach final maturity 30 years
from issuance. Interest is paid semiannually and added to the current value of the bond.
They are designed to reach face value in approximately 17 years although an investor can
hold them for up to 30 years and continue to accrue interest. For bonds issued before May
2005 the rate of interest is recomputed every six months at 90% of the average five-year
Treasury yield for the preceding six months. Bonds issued in May 2005 or later pay a
fixed interest rate for the life of the bond, although the Treasury does guarantee that the
bond will reach face value after 20 years. In the space of a decade, interest dropped from
well over 5% to 1.4% for new bonds in 2008.[5]

Interest is taxable at the federal level only. Investors can elect to defer taxation until the
bond ceases to pay interest (30 years after issuance) or until it is redeemed.

Series EE bonds are designed for individual investors, sold at a discount, and redeemed at
an amount that includes the interest income. Hence, while interest is calculated semi-
annually, the interest on a Series EE bond is not paid until redemption.

[edit] Series HH

Series HH bonds are sold at a discount and mature at face value. Unlike T-Bonds
(Treasury Bonds) and agency issues, Series HH bonds are nonmarketable. They also pay
interest semi-annually, as do most bonds.

Issuance of Series HH bonds stopped as of August 31, 2004, but there are still many yet
that have not matured.[citation needed]

[edit] Series I

Series I bonds are issued at face value and have a variable yield based on inflation. The
interest rate consists of two components: the first is a fixed rate which will remain
constant over the life of the bond and the second is a variable rate reset every six months
from the time the bond is purchased based on the current inflation rate. New rates go into
effect on May 1 and November 1 of every year.[6] The fixed rate is determined by the
Treasury Department; the variable component is based on the Consumer Price Index from
a six month period ending one month prior to the reset time. Like EE bonds, I bonds are
issued to individuals with a limit of $5,000 per person (by Social Security number) per
year. A person may purchase the limit of both paper and electronic bonds for a total of
$10,000 per year. Redeeming the bonds before five years will incur a penalty of three
months of interest.[7] The Treasury Department announced in early November 2008 the
return of a fixed rate component, which the Treasury removed in July. For newly
purchased securities, the Series I will pay 0.7% fixed annual rate, in addition to the
inflation adjustment. Combining the fixed rate and the inflation adjustment as of
November 2008, new I-bonds will earn interest at a 5.64% annual percentage rate.[8]

[edit] History
This section needs additional citations for verification.
Please help improve this article by adding reliable references. Unsourced material may be challenged
and removed. (January 2009)

The US government knew that the costs of World War I would be great and the question
of how to pay for the war was under great debate. The resulting decision was to pay for
the war with a balance between higher taxes (see the War Tax Act) and government debt.
Traditionally, the government borrowed from other countries, but there were no other
country from which to borrow in 1917. The US citizens would have to fully finance the
war through both higher taxes and purchases of war bonds.

The Treasury raised funding throughout the war by floating $21.5 billion in 'Liberty
bonds.' These bonds were sold at subscription where officials created a coupon price and
then sold it at Par value. At this price, subscriptions could be filled in as little as one day,
but usually remained open for several weeks, depending on demand for the bond.

After the war, the Liberty Bonds were reaching maturity, but the Treasury was unable to
pay each down fully with only limited budget surpluses.[citation needed] The resolution to this
problem was to refinance the debt with variable short and medium-term maturities. Again
the Treasury issued debt through a fixed-price subscription, where both the coupon and
the price of the debt were dictated by the treasury.

The problems with debt issuance became apparent in the late-1920's. The system suffered
from chronic oversubscription, where interest rates were so attractive that there were
more purchasers of debt than supplied by the government. This indicated that the
government was paying too much for debt. As government debt was overvalued, debt
purchasers could buy from the government and immediately sell to another market
participant at a higher price.

In 1929, the US Treasury shifted from the fixed-price subscription system to a system of
auctioning where 'Treasury Bills' would be sold to the highest bidder. Securities were
then issued on a pro rata system where securities would be allocated to the highest bidder
until their demand was full. If more treasuries were supplied by the government, they
would be then allocated to the next highest bidder. This system allowed the market to set
the price rather than the government. On December 10, 1929, the Treasury issued its first
auction. The result was the issuing of $224 million three-month bills. The highest bid was
at 99.310 with the lowest bid accepted at 99.152.[9]

[edit] See also

• Government debt
• Interest
• Risk
• War bond

[edit] References
1. ^ "Treasury Reintroduces 30-Year Bond". U.S. Department of the Treasury.
2. ^ "Table of Treasury Securities". U.S. Department of the Treasury.
3. ^ http://www.treasurydirect.gov/indiv/research/faq/legacychanges.htm
4. ^
Template:Http://www.treasurydirect.gov/govt/reports/pd/mspd/2008/opds112008.
pdf
5. ^ "Series EE/E Savings Bond Rates". U.S. Department of the Treasury. Retrieved
on 2008-07-19.
6. ^ I Savings Bond Historical Rates and Terms - Treasury Direct
7. ^ I Bonds at a Glance - Treasury Direct
8. ^ "U.S. adds fixed rate return to new 'i-series'savings bonds". L.A. Times.
Retrieved on 2008-11-05.
9. ^ Garbade, Kenneth D. "Why The U.S. Treasury Began Auctioning Treasury Bills
in 1929." Federal Reserve Bank of New York, Vol. 14, No. 1, July 2008.

External links
• Bureau of the Public Debt : US Savings Bonds Online
• Major Foreign Holders of U.S. Treasury Bonds
• U.S. Bureau of the Public Debt: Series A, B, C, D, E, F, G, H, J, and K Savings
Bonds and Savings Notes.
• Features and Risks of Treasury Inflation Protection Securities
 [hide]
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bond · Fixed rate bond · Floating rate note · High-yield
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debt · Inflation-indexed bond · Inverse floating rate
note · Perpetual bond · Puttable bond · Reverse
convertible · Zero-coupon bond

Asset-backed security · Collateralized debt obligation ·

Securitized Products Collateralized mortgage obligation · Commercial
mortgage-backed security · Mortgage-backed security

Bond option · Credit derivative · Credit default swap ·

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Commercial paper
From Wikipedia, the free encyclopedia

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Stock market
Stock
Preferred stock
Common stock
Registered share
Voting share
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 Spot market

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v•d•e

U.S. Commercial Paper types outstanding at end of each year 2001 to 2007

Total U.S. CP outstanding each week. Note the Federal reserve changes its methods of
calculation

In the global money market, commercial paper is an unsecured promissory note with a
fixed maturity of one to 270 days. Commercial Paper is a money-market security issued
(sold) by large banks and corporations to get money to meet short term debt obligations
(for example, payroll), and is only backed by an issuing bank or corporation's promise to
pay the face amount on the maturity date specified on the note. Since it is not backed by
collateral, only firms with excellent credit ratings from a recognized rating agency will be
able to sell their commercial paper at a reasonable price. Commercial paper is usually
sold at a discount from face value, and carries shorter repayment dates than bonds. The
longer the maturity on a note, the higher the interest rate the issuing institution must pay.
Interest rates fluctuate with market conditions, but are typically lower than banks' rates.[1]

As defined by American law, commercial paper is a financial instrument that matures

before nine months (270 days), and is only used to fund operating expenses or current
assets (e.g., inventories and receivables) and not used for financing fixed assets, such as
land, buildings, or machinery.[2] By meeting these qualifications it may be issued without
U.S. federal government regulation, that is, it need not be registered with the U.S.
Securities and Exchange Commission.[3] Commercial paper is a type of negotiable
instrument, where the legal rights and obligations of involved parties are governed by
Articles Three and Four of the Uniform Commercial Code, a set of non-federal business
laws adopted by each of the 50 U.S. States.

Commercial paper is defined in Canada as having a maturity of not more than one year
and is exempt from dealer registration and prospectus requirements.[4]

At the end of 2007, more than 1,700 companies in the United States issue commercial
paper. As of 2008 October 31, the U.S. Federal Reserve reported seasonally adjusted
figures for the end of 2007: there was $1.7807 trillion (short-scale, or 1,780,700,000,000)
in total outstanding commercial paper; $801.3 billion was "asset backed" and $979.4
billion was not; $162.7 billion of the total was issued by non-financial corporations, and
$816.7 billion was issued by financial corporations.[5]

Contents
[hide]

• 1 History
• 2 Issuing commercial paper
• 3 Commercial paper versus bank line of credit
• 4 Defaults
• 5 See also
• 6 Notes and references

• 7 External links

[edit] History
Commercial paper, in the form of promissory notes issued by corporations, have existed
since at least the 19th century. For instance, Marcus Goldman, founder of Goldman
Sachs, got his start trading commercial paper in New York in 1869. [6]

[edit] Issuing commercial paper

There are two methods of issuing paper. The issuer can market the securities directly to a
buy and hold investor such as most money funds. Alternatively, it can sell the paper to a
dealer, who then sells the paper in the market. The dealer market for commercial paper
involves large securities firms and subsidiaries of bank holding companies. Most of these
firms also are dealers in US Treasury securities. Direct issuers of commercial paper
usually are financial companies that have frequent and sizable borrowing needs and find
it more economical to sell paper without the use of an intermediary. In the United States,
direct issuers save a dealer fee of approximately 5 basis points, or 0.05% annualized,
which translates to $50,000 on every $100 million outstanding. This saving compensates
for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to
be lower outside the United States.

[edit] Commercial paper versus bank line of credit

Commercial paper is a lower cost alternative to a line of credit with a bank. Once a
business becomes large enough, and maintains a high enough credit rating, then using
commercial paper is always cheaper than using a bank line of credit. Nevertheless, many
companies still maintain bank lines of credit to act as a "backup" to the commercial
paper. In this situation, banks often charge fees for the amount of the line of the credit
that does not have a balance. While these fees may seem like pure profit for banks, if the
company ever actually needs to use the line of credit it would likely be in serious trouble
and have difficulty repaying its liabilities.

[edit] Defaults
Defaults on high quality commercial paper are rare, and cause concern when they occur.[7]
Notable examples include:

• June 1970: Penn Central, $82 million

This led to Fed intervention.[7]

• January 31, 1997: Mercury Finance (a major automotive lender), $17 million,
rising to $315 million

Effects were small, partly because default occurred during a robust economy.[7]

• September 15, 2008: Lehman Brothers

This caused two money funds to break the buck, and led to Fed intervention in
money market funds.

[edit] See also

• Asset-backed commercial paper
• Negotiable instrument

[edit] Notes and references

1. ^ What is commercial paper, and why does it matter?,
http://www.iht.com/articles/ap/2008/10/07/america/Meltdown-Commercial-Paper-Q-
A.php, retrieved on 13 October 2008
2. ^ Hahn, Thomas K.; Timothy Q. Cook and Robert K. Laroche (1993). "Commercial
Paper," Ch. 9, in Instruments of the Money Market. Richmond, VA: Federal Reserve
Bank of Richmond. pp. 106–07.
http://www.richmondfed.org/publications/research/special_reports/instruments_of_the_m
oney_market/pdf/chapter_09.pdf.
3. ^ 15 U.S.C. Section 77c(a)(3)
4. ^ Ontario Securities Commission National Instrument 45-106 (Section 2.35) Accessed
2007-01-30
5. ^ Federal Reserve. "FRB: Commercial Paper Outstanding". Retrieved on 2008-10-
31. "Data as of October 29, 2008"
6. ^ Uhtermyer Urges Money Bill Changes; Approves Measure, but Wants Commercial
Paper Defined in Its Strict Meaning in The New York Times of September 23, 1913
Commercial Paper Should Be Changed; Gardin Thinks Three Years Sufficient for
Transition to European Practice in The New York Times of March 1, 1914
 7. ^ a b c Stojanovic, Dusan; Vaughan, Mark D., The Commercial Paper Market: Who's
Minding the Shop?, http://www.stls.frb.org/publications/re/1998/b/re1998b3.html,
retrieved

Municipal bond
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v•d•e

In the United States, a municipal bond (or muni) is a bond issued by a city or other local
government, or their agencies. Potential issuers of municipal bonds include cities,
counties, redevelopment agencies, school districts, publicly owned airports and seaports,
and any other governmental entity (or group of governments) below the state level.
Municipal bonds may be general obligations of the issuer or secured by specified
revenues. Interest income received by holders of municipal bonds is often exempt from
the federal income tax and from the income tax of the state in which they are issued,
although municipal bonds issued for certain purposes may not be tax exempt.

Contents
[hide]

• 1 Purpose of municipal bonds

o 1.1 Municipal bond issuers
o 1.2 Municipal bond holders
• 2 Characteristics of municipal bonds
o 2.1 Taxability
• 3 Risk
• 4 Disclosures to investors
• 5 Comparison to corporate bonds
• 6 Subprime mortgage crisis
• 7 Default Rates
• 8 References

• 9 External links

[edit] Purpose of municipal bonds

[edit] Municipal bond issuers

Municipal bonds are issued by states, cities, and counties, or their agencies (the
municipal issuer) to raise funds. The methods and practices 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.

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.[1] 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..

[edit] 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.
Municipal bond issued in 1929 by town Kraków (Poland)

[edit] Characteristics of municipal bonds

[edit] Taxability

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.

The laws governing the taxability of municipal bond income are complex; however,
bonds are typically certified by a law firm as either tax-exempt (federal and/or state
income tax) or taxable before they are offered to the market. Purchasers of municipal
bonds should be aware that not all municipal bonds are tax-exempt.

[edit] Risk
Main article: credit risk
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.

[edit] Disclosures to investors

Key information about new issues of municipal bonds (including, among other things, the
security pledged for repayment of the bonds, the terms of payment of interest and
principal of the bonds, the tax-exempt status of the bonds, and material financial and
operating information about the issuer of the bonds) typically is found in the issuer's
official statement. Official statements generally are available at no charge from the
Electronic Municipal Market Access system (EMMA) at http://emma.msrb.org operated
by the Municipal Securities Rulemaking Board (MSRB). For most municipal bonds
issued in recent years, the issuer is also obligated to provide continuing disclosure to the
marketplace, including annual financial information and notices of the occurrence of
certain material events (including notices of defaults, rating downgrades, events of
taxability, etc.).

[edit] Comparison to corporate bonds

Because municipal bonds are most often tax-exempt, comparing the coupon rates of
municipal bonds to corporate or other taxable bonds can be misleading. Taxes reduce the
net income on taxable bonds, meaning that a tax-exempt municipal bond has a higher
after-tax yield than a corporate bond with the same coupon rate.

This relationship can be demonstrated mathematically, as follows:

 Failed to parse (Cannot write to or create math output directory): r_m = r_c
( 1 - t ) \,

where

• rm = interest rate of municipal bond

• rc = interest rate of comparable corporate bond
• t = tax rate

For example if rc = 10% and t = 38%, then

Failed to parse (Cannot write to or create math output directory): r_m =

(10%)(100% - 38%) = 6.2% \,

A municipal bond that pays 6.2% therefore generates equal interest income after taxes as
a corporate bond that pays 10% (assuming all else is equal).

Alternatively, one can calculate the taxable equivalent yield of a municipal bond and
compare it to the yield of a corporate bond as follows:

Failed to parse (Cannot write to or create math output directory): r_c =

\frac{r_m}{( 1 - t )}

Because longer maturity municipal bonds tend to offer significantly higher after-tax
yields than corporate bonds with the same credit rating and maturity, investors in higher
tax brackets may be motivated to arbitrage municipal bonds against corporate bonds
using a strategy called municipal bond arbitrage.

Some municipal bonds are insured by monoline insurers that take on the credit risk of
these bonds for a small fee.

[edit] Subprime mortgage crisis

Main article: Subprime mortgage crisis#Effect on municipal bond "monoline"
insurers

The municipal bond market was affected by the subprime mortgage crisis. During the
crisis, monoline insurers that insured municipal bonds incurred heavy losses on the
collateralized debt obligations (CDOs) and other structured financial products that they
also insured. Consequently, the credit ratings of these monoline insurers were called into
question, and the prices of municipal bonds fell.
[edit] Default Rates
The historical default rate for municipal bonds is lower than that of corporate bonds. The
Municipal Bond Fairness Act (HR 6308)[2], introduced September 9 2008, included the
following table giving bond default rates up to 2007 for municipal versus corporate bonds
by rating and rating agency.

Cumulative Historic Default Rates (in percent)

------------------------------------------------------------------------
Moody's S&P
Rating categories ---------------------------------------
Muni Corp Muni Corp
------------------------------------------------------------------------
Aaa/AAA......................... 0.00 0.52 0.00 0.60
Aa/AA........................... 0.06 0.52 0.00 1.50
A/A............................. 0.03 1.29 0.23 2.91
Baa/BBB......................... 0.13 4.64 0.32 10.29
Ba/BB........................... 2.65 19.12 1.74 29.93
B/B............................. 11.86 43.34 8.48 53.72
Caa-C/CCC-C..................... 16.58 69.18 44.81 69.19
Investment Grade................ 0.07 2.09 0.20 4.14
Non-Invest Grade................ 4.29 31.37 7.37 42.35
All............................. 0.10 9.70 0.29 12.98
------------------------------------------------------------------------

[edit] References
1. ^ Tax regulations
2. ^ http://frwebgate.access.gpo.gov/cgi-
bin/getdoc.cgi?dbname=110_cong_reports&docid=f:hr835.110