Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Municipal Bonds Really Fund Your City
Transcript
- Lucas: There is a four-trillion-dollar market that most people never think about, but it quietly shapes nearly every public building, road, and water pipe in America. I'm talking about municipal bonds. Luna: Muni bonds — the ones cities and states issue to fund big projects. But four trillion? That's bigger than I thought. Lucas: It is. As of early 2026, there's about four point one trillion dollars in outstanding municipal debt. To put that in perspective, it's roughly the size of the entire UK economy. Luna: And yet most people have no idea how they work, or that their own city might be borrowing through them right now. Lucas: Exactly. So let's start with the basics. A municipal bond is essentially a loan from an investor to a local government. The government promises to pay back the principal plus interest over a set period. The interest is typically exempt from federal income tax, and often state and local tax too. Luna: That tax exemption is the big draw, right? It lets cities borrow at lower interest rates than they'd otherwise pay. Lucas: Right. Because investors accept a lower yield in exchange for the tax break. So a city might pay three percent on a muni bond when a comparable corporate bond would yield four and a half percent. That saving gets passed down to taxpayers. Luna: But it's not just for big cities like New York or Chicago. Small towns use them too, for things like sewer upgrades or new fire trucks. Lucas: That's right. There are roughly fifty thousand state and local governments in the US that issue bonds. The market is incredibly fragmented. But here's the thing — not all muni bonds are created equal. There are two main types: general obligation bonds, backed by the full taxing power of the issuer, and revenue bonds, backed by a specific revenue stream like tolls or water fees. Luna: And revenue bonds are riskier because if the toll road doesn't collect enough tolls, the bondholders might not get paid. Lucas: Exactly. And that brings us to a real-world case. Let's talk about Jackson, Mississippi. In 2022, the city's water system collapsed — thousands of residents lost running water for weeks. The underlying issue wasn't just a cold snap. It was decades of underinvestment in infrastructure. Luna: And Jackson had issued revenue bonds backed by water fees to fund part of that system. But the money wasn't enough to cover needed repairs. Lucas: Right. Jackson's water and sewer revenue bonds had been downgraded to junk status years earlier. That meant the city had to pay higher interest rates to borrow, which made it even harder to afford upgrades. It's a vicious cycle. Luna: So the bond market essentially priced in the risk of Jackson's financial distress, but that higher cost of capital made the problem worse. Lucas: Exactly. And Jackson isn't alone. According to a 2024 study from the Federal Reserve, about one in five small cities and towns in the US has a credit rating below investment grade. That means they're effectively locked out of affordable borrowing. Luna: So who buys these bonds? I know wealthy investors love the tax exemption, but is it mostly individuals? Lucas: It's a mix. Individual investors, through mutual funds and ETFs, hold about forty-five percent of the market. Banks and insurance companies hold another thirty percent. And the rest is held by institutional investors like pension funds and hedge funds. Luna: And that concentration among wealthy individuals and institutions — does it raise any equity concerns? Because the tax break mostly benefits people in high tax brackets. Lucas: That's a really good point. Critics argue that the tax exemption is a regressive subsidy — it primarily helps high-income investors who itemize deductions, while the benefits to the broader public are indirect. A 2023 paper from the Brookings Institution estimated that the federal government forgoes about thirty billion dollars in tax revenue each year because of muni bond interest exclusion. Luna: Thirty billion. That's a lot of money that could be spent on infrastructure directly, rather than through a tax loophole. Lucas: Exactly. Some economists have proposed replacing the tax exemption with a direct federal subsidy to state and local governments. That would be more transparent and could target funds to communities that need them most. Luna: But that would also mean less demand from wealthy investors, which could push borrowing costs up for cities. Lucas: That's the trade-off. And it's a politically tough sell. The muni bond industry is deeply entrenched. But there's another trend worth watching: the rise of esg labeled municipal bonds. Luna: ESG — environmental, social, governance. How does that apply to munis? Lucas: More and more issuers are labeling bonds as 'green' if the proceeds go to environmental projects like renewable energy or clean water. Social bonds fund things like affordable housing. By early 2026, esg labeled muni bond issuance had grown to about sixty billion dollars a year, up from practically nothing five years ago. Luna: And do those bonds actually get better pricing? I've read mixed evidence. Lucas: The evidence is mixed. Some studies find a slight 'greenium' — a few basis points lower yield — but it's not consistent. Part of the problem is a lack of standardization. What counts as green? There's no universal certification. Luna: So it's partly a marketing tool, but it also signals that the issuer is taking long-term risks seriously. Lucas: Exactly. And that can matter for credit quality. A city that invests in climate resilience might have a better credit outlook than one that ignores it. But let's bring this back to the listener. If you're a taxpayer, your local government's bond rating affects your property taxes and the quality of your public services. Luna: So what can a regular person look for to understand their own city's fiscal health? Lucas: Check your city's credit rating. Moody's and S&P publish ratings for most municipalities. Look at the debt per capita. And pay attention to pension obligations — those off-balance-sheet liabilities can be huge. For example, in Chicago, pension debt is over twenty thousand dollars per resident. Luna: That's staggering. And it's not just Chicago. Many older cities in the Northeast and Midwest have similar problems. Lucas: Right. And the bond market is forward-looking. When a city's pension costs rise, its borrowing costs rise too, because investors see higher risk. So there's a direct feedback loop between fiscal discipline and the cost of capital. Luna: One thing I've always wondered — what happens if a city actually defaults? I know Detroit went through bankruptcy in 2013. Lucas: Municipal defaults are rare, but they do happen. Detroit's bankruptcy in 2013 was the largest in US history, affecting about seven billion dollars in bonds. Bondholders took significant haircuts — some recovered only about twenty cents on the dollar. But since then, the market has added protections. Many bonds now have debt service reserve funds and bond insurance. Luna: Bond insurance — where a private company guarantees payment if the issuer can't pay. That was huge before 2008, then it collapsed after the financial crisis. Lucas: Right. The big insurers like MBIA and Ambac nearly failed themselves. But the industry has revived. Today, about six percent of new muni bonds are insured, up from a low of two percent a decade ago. Companies like Build America Mutual and Assured Guaranty have taken the lead. Luna: So insurance adds a layer of safety, but it also costs money. For a small city, is it worth it? Lucas: It depends on their rating. If a city is already AA, insurance might not save much. But if they're BBB, insurance could lift the bond to AA, dramatically lowering the interest rate. The savings often outweigh the insurance premium. Luna: I want to go back to the tax exemption question. With a thirty-billion-dollar annual tax expenditure, why hasn't Congress reformed it? Lucas: Because the muni bond lobby is powerful. The Government Finance Officers Association, the National League of Cities — they all argue that eliminating the exemption would raise borrowing costs for states and cities, hurting infrastructure spending. And they have a point. But there's also a fairness argument. Luna: And the reality is that most voters don't even know the market exists, so there's no grassroots pressure for reform. Lucas: Exactly. It's one of those quiet fiscal policies that shapes billions of dollars in spending without ever making headlines. But it's worth understanding because it affects everything from the potholes on your street to the quality of your local schools. Luna: So if you see a bond referendum on your local ballot — and I know many of us have — what should you look for? Lucas: Look at what the money is actually for. Is it a specific project with a clear cost estimate? Or is it a general purpose authorization? Check if the city has a history of completing projects on time and on budget. And see whether they're issuing general obligation bonds — which voters have to approve — or revenue bonds, which often don't require a vote. Luna: Good advice. And with interest rates still elevated in 2026, the cost of borrowing is higher now than it was a few years ago. That makes it even more important for cities to be disciplined. Lucas: Absolutely. The Federal Reserve's rate hikes have raised muni yields across the board. A ten-year aa rated muni bond was yielding about three point two percent in early 2026, compared to under two percent in 2021. That means cities are paying more to borrow, which can delay projects. Luna: But on the flip side, higher yields attract more investors. So the market remains liquid. Lucas: Right. And for individual investors, muni bonds can still be a good diversifier in a taxable portfolio, especially if you're in a high tax bracket. But you have to be careful about credit risk, interest rate risk, and call provisions. Luna: Call provisions — where the issuer can repay the bond early if rates fall. That's a risk for bondholders. Lucas: Exactly. So the muni market is more complex than it appears. But at its core, it's a fascinating example of how public finance and private capital intersect. Every time you drive over a bridge or turn on a tap, you're benefiting from a bond that someone bought years ago. Luna: And the next time you see a 'vote yes for schools' sign, you'll know what's really at stake — not just a tax increase, but a bond market decision that will affect your community for decades. Lucas: I think that's a good place to leave it. Next time, we'll look at how the federal government's credit programs — like those from the Export-Import Bank — work as a form of industrial policy. Luna: Looking forward to it. Thanks, Lucas. Lucas: Thanks, Luna.