Building Bridges

Below is a full transcript of this video presentation. It has not been edited or reviewed for accuracy or readability.

Lucas loves his car even though it is a hand-me-down from his brother, Darwin. The car is almost 12 years old and while it still drives well, it is showing signs of wear. Recently, he has noticed that his car doesn't drive as smooth or straight as it used to, and his mechanic says he needs repairs to his suspension and his wheels are out of alignment. The poor conditions of his town's streets are taking a toll on Lucas' car. More than once he has come close to crashing his car in an attempt to avoid a new pothole.

Lucas wants to fix his car, but every time he thinks he has saved enough money, he needs more. Sometimes it is because the repair or new parts cost more than he thought it would. Other times, a new, unforeseen problem pops up. After thinking it over, Lucas decided to ask his brother for money to fix everything on his car all at once.

Like Lucas, towns and cities borrow money too. The mayor of Lucas' town has also noticed the poor condition of its streets. She wants to fix them permanently, but there isn't enough money in the current budget to do more than temporarily fill potholes. She discussed the situation with the town council and together they decided it would be in the town's best interest to borrow the money needed to pay for a long-term solution to the damaged streets. It's pretty easy for Lucas to borrow money from his brother, but how does a town borrow money?

When a town or city needs money for projects like building bridges, repairing roads or developing streets and parks, the town or city can borrow money by issuing a bond. A bond is an agreement between a government agency or company and an investor. A bond requires the borrower (the agency or company) to repay the loan with interest to the investor by a certain date.

Companies also issue bonds, using them to pay for the creation of new products and services and the improvement of existing products and services, among other projects.

Companies can also raise money using stocks. Governments can only use bonds so they rely on issuing them to fund projects like building new schools, preserving historic landmarks and, in the case of Lucas' town, repairing bridges, worn streets and roadways.

There are four general types of bonds:

1. Corporate bonds - which are issued by companies
2. Municipal bonds - which are issued by state and local governments
3. Agency bonds - which are issued by government sponsored, but privately owned corporations and some federal government agencies
4. U.S. Treasury bonds - which are issued by the Federal government to borrow money when its expenses exceed its revenue

Lucas' town was able to issue a "municipal bond" or "muni" through the bond market. The bond market is a part of the capital markets. The bond market brings borrowers—the cities and towns—and lenders—people like you and me—together. People in the cities and towns, like Lucas, benefit from the bond market because it helps to fund improvements to their community, such as better roads, bridges and other services. The people who buy the bonds—the lenders—benefit because they receive a return (the interest they earn) on the bonds that they can use in the future.

Why do people want to buy municipal bonds? Well, generally it's because municipal bonds are considered a low-risk investment. That means when people buy a bond, there is a low chance that it won't be repaid—and a low chance of losing our money. However, low risk does not mean "no risk." There is a small chance that the town could fall into debt and not be able to repay the loan. This is referred to as "credit risk."

Investors buy bonds at their par or face value. This means the value written on the bond—typically $100 or $1000. Investors earn money on the bond's coupon rate. A coupon rate is the interest a bond pays on a fixed schedule (usually annually or semi-annually). Coupon payments from municipal bonds are exempt from federal taxes—in other words, the US government doesn't require people who own municipal bonds to pay tax on the money they earn from a municipal bond.

Investors may choose to buy a "zero coupon bond." A zero coupon bond does not pay interest on a fixed schedule. Instead, it pays the interest you are owed when it matures (or when your loan period ends). The maturity date of a bond is when the borrower must repay the loan plus interest. Zero coupon bonds are sold at a price below their face value. When the bond matures, the person who owns the bond receives the face value of the bond. The difference between the price the bond owner paid and the amount they receive when the bond matures is their interest payment.

Let's go back and see how Lucas and the town are doing.

It looks like Lucas' brother, Darwin, agreed to lend Lucas the money he needed to fix his car, and around the same time, the town raised enough money from investors by selling municipal bonds to fix the streets.

Lucas' car will soon be driving better—and so will the streets he drives on!