What is a Bond?
A bond is a certificate representing a promise from the issuer to pay a specified sum of money (face value or principal amount) at a specified date or dates in the future with periodic payments of interest at a specified rate.
Municipal bonds are identifiable by four items, which include:
These items are common to all bond issues and are keys to understanding the municipal bonding process. Later sections of this chapter will discuss other features commonly associated with the issuance of bonds.
The first essential item contained on any bond is the name of the issuer. In most cases, bonds issued to pay for the costs associated with water or sewer systems will be issued by either municipal governments or county water or sewer districts. The board of directors of county water and/or sewer district has the authority, to issue bonds after approval is granted through a public referendum. Local governments can also issue bonds to pay for projects undertaken through the formation of special or rural improvement districts, and are repaid through assessments on property owners in the districts.
The interest on a bond is the compensation paid or to be paid for the use of money. Interest is most commonly expressed as an annual percentage rate. In the case of municipal bonds, interest is paid semiannually by the issuer to the bondholder (investor). Most municipal bonds have interest rates which are either fixed at the time the bond is issued and remain the same over the life of the bond (called "fixed-rate bonds”) or have an interest rate that varies for the term of the issue (called “variable-rate bonds”).
The "maturity structure" of a bond issue identifies the dates upon which the investor will receive payments of principal and interest. This structure is basically determined from the annual need for cash and the length of time the debt will extend. As a basic principal of government finance, money should not be borrowed for a longer period than the life of the capital improvement it will construct or purchase. In the case of water or sewer facilities, the bond should be repaid while some useful life remains in the facility. The maturity structure (or repayment schedule) a community selects should consider the existing debt retirement structure, expected revenues during the repayment period, and the rate at which the community will receive benefits from the new facility. The repayment patterns used by communities are classified as serial maturity, term maturity, or irregular maturity.
"Serial maturity" structures allow the principal to be repaid in periodic installments over the lifetime of the issue. This structure allows for repayment of equal amounts of principal each year, which in turn reduces annual interest costs. "Term maturity" structures require only annual interest payments be made to bond holders and that the principal amount borrowed be repaid in one lump sum when the bond reaches final maturity. Bonds may also be issued with "irregular maturity" structures in which repayment of principal and interest may follow any schedule. This maturity structure allows local governments to tailor the repayment of debt to fit the anticipated future situation of the community.
The "yield" of a municipal bond refers to the return the bond purchaser receives on his investment. This yield reflects the interest rate, length of time to maturity, and whether the bond was purchased at a premium or discount. When the interest payment is fixed, the price of bonds available to investors must change in order to keep the yield competitive with other newly issued bonds. The yield from municipal bonds may fluctuate due to changes in the economy, changes in the credit worthiness of the issuer, or changes in the demand for bonds by investors.
