Municipal bond defaults: what do they mean?

Filed in archive financing on August 28, 2010

© Tracy O

Just as many businesses sell stock on the public market, allowing anyone who has the money to buy shares in the company and reap the success (or failure), so too can state and local organizations issue what are known as "municipal bonds." These serve a similar purpose. The organizations, such as cities or school districts, raise money from the people who buy the bonds, and then pay those bond holders interest on their investment over time.

With corporate bonds, investors may potentially buy enough to hold a controlling stake in the company, in which case they can decide its direction and even remove the leadership if they don't believe the leaders are doing a good job. This is the risk a business takes when it "goes public," opening itself up to an outside judgment that carries a personal, as well as an economic weight. It's not quite the case if an entity buys enough municipal bonds. When entities buy bonds, they suddenly own the city that issued those bonds. Bond holders still have a financial incentive to see to the issuer's success.

The nice thing about municipal bonds is that this personal investment of the bond holders may mean improvements to the issuer, which are good for everyone. For example, someone holding bonds in a school district might push for higher standards so that the school district improves performance. This makes more money for the bond holder, but also makes better education for the youth.

Still, every silver lining has a cloud. Investment is a risk, which means there's the chance of success but also failure. When a bond issuer's fortunes fare poorly, it may not be able to meet its obligations to the bond holders. where there are municipal bond defaults, bankruptcy is right around the corner. As such, as in all investment, potential bond holders must act with care.