States that are facing liquidity problems and cannot easily gain access to capital may raise money through municipal bonds. Municipal bonds can be issued by individual states or local government agencies within a state. States face funding shortfalls for various reasons, including poor budgeting or challenging economic and market conditions. Offering bonds in the debt markets can help a state to maintain infrastructure development or prevent default on major financial obligations, for instance.
States that are facing liquidity problems may choose to issue municipal bonds because of the terms associated with these loans. The interest rates that states or municipalities are obligated to pay to bond investors are typically lower than more traditional borrowing rates. Corporations and the federal government typically pay investors higher interest than municipal bond issuers. Despite modest interest payments, investors receive other benefits. Municipal bond interest payments are not taxed by the federal government. Investors who purchase municipal bonds in the states where the securities were issued bypass state tax on interest distributions, as well.
States and municipalities that need quick access to cash can use the money from municipal bond offerings to finance the infrastructure needs in a community. For instance, the money can be used to build roadways and to construct public buildings, such as schools and hospitals. The money can also be used to providing funding to public retirement plans, such as pension funds. In February 2011, Illinois prepared to issue $3.7 billion in municipal bonds in an attempt to cover a funding shortfall in the state's public pension plan, according to "The New York Times."
The two primary types of municipal bonds are general obligation bonds and revenue bonds. GOBs are typically issued to finance the construction or improvement of public buildings or roads. Bond issuers repay these debt securities using tax income. Revenue bonds are more exclusive in nature and are offered to finance the activities of the issuing entity, such as an airport. Issuers use any fees that are earned at the facility to repay revenue bonds.
A state can run into trouble when it is facing liquidity problems and seeks to issue municipal bonds. In 2009, the state of California faced tremendous liquidity problems. California's credit rating, which affects the state's ability to borrow money, suffered. Subsequently, the state sought the backing of the federal government to validate its credit worthiness. Given the risk associated with lending money to the state, California needed the government's validation in order to keep borrowing costs tied to bond issuance from escalating, according to PIMCO analyst David Blair, as cited on the Market Watch website.
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