Municipal bond financing grew in importance when the Revenue Act of 1913 legislated that income on muncipal bonds was free from federal taxes. Further expansion came from a growing America's tremendous demand for schools, highways, power companies and other physical needs.

Of the 80,000 state and local governments in the United States, about 50,000 have issued bonds, and it is estimated that the total number of separate municipal bond issues currently outstanding numbers about 250,000.

The Municipal Bond Handbook defines the principal types of bonds and notes this way: Bonds

From the standpoint of investment security, there are two types of municipal bonds, differentiated by the amount of revenue behind the bond. One is the general obligation bond, the other the revenue bond.

General obligation (GO) bonds are debt instruments issued by states, counties, special districts, cities, towns and school districts. They are secured by the issuers' taxing powers. Usually a GO bond is secured by the issuers' unlimited taxing power. For smaller governmental jurisdictions such as school districts and towns, the only available unlimited taxing power is on property.

For larger GO bond issuers such as states and big cities, the tax revenues are more diverse and may include corporate and individual income taxes, sales taxes and property taxes. The security pledges for these larger issuers are sometimes referred to as being full faith and credit obligations.

Additionally, certain GO bonds are secured not only by the issuer's general taxing powers to create revenues from which to service the debt but also by certain identified fees, grants and special charges, which provide additional revenues to service the debt. Such bonds are known as being "double barreled" in security because of the dual nature of the revenue sources.

Also, not all GO bonds are secured by unlimited taxing powers. In some cases, the bonds are backed by taxes that are limited as to revenue source and maximum rates. Such bonds are known as limited-tax GO bonds.

Revenue bonds bonds are issued to finance a particular project or enterprise, with the revenue from the venture pledged to the bond holders. These bonds support projects such as single- and multi-family housing, public power plants, pollution control facilities, airports, hospitals, water and sewer plants, and industrial development.

In addition, there are some hybrid and special municipal bonds that have more unique security structures as well. These include:

Insured bonds -- In addition to being secured by the issuer's revenues, these bonds are backed by insurance policies written by commercial casualty insurance companies. The insurance provides prompt payment to the bond holders if a default should occur.

Letter-of-credit backed bonds -- Some municipal bonds, in addition to being secured by the issuer's cash flow revenues, are backed by commercial bank letters of credit.

These LOCs can be either irrevocable, when they can be used to pay bond holders, or revocable, and are valid only if certain criteria are met by the issuers. Knowledge of the credit-worthiness of the bank issuing an LOC as well as the type of LOC is an important factor for the investor.

Refunded bonds -- These are bonds that originally may have been issued as GO or revenue bonds but are now secured by an "escrow fund" consisting entirely of U.S. treasuries that are sufficient for paying bond holders when the bonds are called or mature. As refunded bonds, they are rated AAA.

There are two recent innovations to add to the list. One is the "put" or "option tender" bond, which entitles the bond holder to return the bond at a price of par to the bond trustee prior to its stated long-term maturity. These "put" dates could be in the third year or the 10th year from the original issue date. "Put" bonds are a hedge against rising interest rates.

Variable-rate coupon bonds or "floaters" are another innovation. They have floating interest rates that are tied to various indices and change on a weekly, monthly or quarterly basis. Variable-rate bonds also are a hedge against rising interest rates and usually come in minimum denominations of $100,000. Notes

Tax-exempt debt issued for periods ranging not beyond three years usually are considered short term in nature. The following types are temporary borrowings by states, local governments and special jurisdictions, and are usually issued for a period of 12 months. They are tax, revenue, grant and bond anticipation notes. Another short-term vehicle ranging from 30 to 270 days would be tax-exempt commercial paper. Finally, construction loan notes (CLNs) are usually issued for periods up to three years to provide short-term construction financing for multiple-family housing projects. Investment Strategies

Municipal bonds have four main attractions to investors. First is their relatively high level of safety or security of principal. Although there have been instances where the issuers failed to make payments to bond holders, these have been rare. Second, tax-exempt municipal bonds are exempt from federal income taxes and generally are exempt from state income taxes in the state where the issuer is located. Third, a ready market exists in most tax-exempts so that a bond or notes can easily be traded. Fourth is diversity. There is an almost unlimited array of municipal bonds from all geographical areas of the nation with an unlimited choice of maturities and a constant supply of new issues to satisfy would-be purchasers.

Since municipal bonds are tax exempt, they sell at lower yields (returns) than taxable bonds. A taxable bond with triple-A rating averaged 12.56 percent in March, while an index of 20 municipals published by Bond Buyer was yielding 9.77 percent that month. Thus, an investor had to give up 22 percent of his or her yield to get the tax-exempt bond. All other things being equal, if an investor is in a tax bracket higher than 22 percent, the after-tax yield is greater with the tax-exempt bond. Issue Structure

Most GO bonds are issued or sold with "serial" maturities -- that is, a fixed number of the bonds mature annually over a period of up to 25 years. Most revenue bonds have serial maturities as well as one or more term maturities. In both types, bonds may be called in and paid off by the issuer, generally seven to 10 years after they are issued. As many revenue bonds may have one or more large long maturities (term bonds) ranging from 20 to 40 years, a sinking fund may be used to retire bonds beginning seven, 10 or 15 years after the issue is sold.

New tax-exempts are sold on a yield to maturity basis. The price is expressed on a percentage return (yield) figured to maturity. Most serial bonds are sold on a yield basis. Some bonds, especially large revenue bonds with a single or several long maturities (term bonds), are sold and quoted in dollars. They are known as "dollar bonds."

Today, most tax-exempts are sold in minimum denominations of $5,000. Prior to July 1, 1983, municipal bonds were issued in either coupon form or registered as to principal only. After July 1, 1983, all municipal bonds have been issued in registered form only. This means that the bond holder's name is registered with the issuer, who will send interest and principal payments directly to the bond holder. Underwriting

Municipal bonds are underwritten and distributed by syndicates made up of of brokers and commercial banks. These underwritings may be either negotiated (one syndicate) or bid for competitively by several syndicates. The bidder who pays the highest price for the entire issue buys the loan. The bonds are then reoffered to the public at a higher price. An advertisement usually appears in newspaper financial pages listing the maturities, yields and the underwriters from whom bonds may be purchased.

Any underwriter of a particular issue should be able to furnish a buyer with a "preliminary statement" concerning an issue prior to its sale and must provide a final "prospectus" after the sale. The investor should take advantage of the information provided to be sure of the various features of his purchase -- and to have peace of mind. Legal Opinion

When an entity decides to sell a municipal bond, competent municipal bond counsels are engaged to analyze the offering and determine that the bonds are binding obligations of the issuers according to state and local statutes. Second, they verify the tax-exempt status of the interest payments the bond holder will be receiving according to federal and local laws. Today, most bonds have the legal opinion printed on the back of the bond. Older bonds have the "legal" printed separately, and buyers should always request and obtain this option before purchasing a municipal. Without the legal opinion, it could be very difficult for the investor to sell a bond, especially older issues. Credit Ratings

Moody's and Standard & Poor's credit-rating services analyze the financial soundness of the various issuers and their ability to service their debt. Based on their findings, a credit rating is assigned to individual issues. It is advisable that only bonds rated AAA, AA, A or BAA be purchased. The lower the rating, the more difficult it may be for an issuer to service the debt. Insured bonds are enhanced by the added protection and the resulting higher AAA credit rating.

Investors can buy newly issued bonds from underwriters or previously issued bonds from dealers, who make up what is called the secondary market. The Blue List, a trade publication, lists bonds and short-term notes available on the secondary market. All brokerage houses have a copy of the Blue List, an invaluable tool for the investor.