Municipal Bonds

Beyond the GO-versus-revenue split, the exam tests short-term municipal notes, industrial development bonds, bond insurance, and the tax-equivalent yield formula. Each is a distinct testable point below.

What Are the Types of Municipal Bonds?

What Are GO Bond Characteristics?

• Backed by the full faith, credit, and taxing power of the issuing municipality
• Repaid from ad valorem (property) taxes and general tax revenues
• Typically require voter approval
• Considered safer than revenue bonds from the same issuer

What Are Revenue Bond Characteristics?

• Backed by revenue from a specific project or facility (toll road, hospital, airport, utility)
• No taxing power backing; if the project fails to generate revenue, bondholders may not be paid
• Do not require voter approval
• Include a feasibility study before issuance
• Typically offer higher yields than GO bonds from the same issuer (more risk)
• Protected by a rate covenant (issuer must maintain user fees/rates sufficient to cover debt service)

How Do GO and Revenue Bonds Compare?

What Other Municipal Securities Should You Know?

Industrial Development Revenue Bonds (IDRBs): Issued by municipalities to finance private facilities. Backed by the private corporation (not the municipality). May be subject to Alternative Minimum Tax (AMT).

Short-term municipal notes: Used to bridge temporary cash flow gaps:

• TANs (Tax Anticipation Notes) - repaid from expected tax receipts
• RANs (Revenue Anticipation Notes) - repaid from expected revenues
• BANs (Bond Anticipation Notes) - repaid from proceeds of a future bond issue

Exam Tip: Gotchas

• IDRBs are backed by the corporation's credit, not the municipality. The city is just a conduit issuer. Municipal bond interest may be subject to AMT if issued as a private activity bond.

What Do Insured Municipal Bonds Guarantee?

• Backed by a third-party insurance company that guarantees timely payment of principal and interest
• Insurance raises the bond's credit rating to that of the insurer. Historically this meant AAA, but no active municipal bond insurer has carried a AAA rating since the 2008 financial crisis; today's insurers are rated in the AA range
• Insured bonds trade at lower yields than uninsured bonds of the same issuer
• Insurance does not protect against market/interest rate risk; only credit risk

Think of it this way: Bond insurance transfers credit risk to the insurer. Even if the municipality struggles financially, the insurance company guarantees payment. The trade-off is a lower yield.

Exam Tip: Gotchas

• Insured municipal bonds protect against credit risk only, not interest rate risk. They carry the insurer's rating, today typically in the AA range rather than the AAA some older material still assumes.

How Are Municipal Bonds Taxed?

• Interest is generally exempt from federal income tax
• May be double-exempt (federal + state) if investor resides in the issuing state
• May be triple-exempt (federal + state + city) in certain jurisdictions (e.g., New York City)
• Capital gains on municipal bonds are taxable (only interest is tax-exempt)

Exam Tip: Gotchas

• Municipal bond interest is tax-exempt, but capital gains are fully taxable. GO bonds are backed by taxing power and need voter approval; revenue bonds are backed by project revenue and do NOT need voter approval.

How Do You Calculate Tax-Equivalent Yield (TEY)?

To compare municipal bonds to taxable bonds:

Example: 4.2% municipal, investor in 40% bracket:

• TEY = 4.2% ÷ (1 - 0.40) = 4.2% ÷ 0.60 = 7.0%
• The investor would need a 7% taxable bond to equal the 4.2% municipal after taxes

Reverse Calculation: What tax-free yield equals a taxable yield?

• Taxable yield × (1 - Tax bracket) = Tax-free equivalent
• 8% × (1 - 0.30) = 8% × 0.70 = 5.6%

Exam Tip: Gotchas

• The higher your tax bracket, the more valuable tax-exempt income becomes. If the exam gives a combined federal and state rate, use that full rate in the formula. A 4% muni equals about a 7% taxable bond at a 43% combined rate, but only a 5.3% equivalent at a 25% rate.

What Should You Check on Exam Day?

• GO bonds: backed by taxing power, usually need voter approval, lower risk and yield
• Revenue bonds: backed by project revenue, no voter approval, feasibility study, rate covenant
• IDRBs are backed by the private corporation, not the municipality, and may trigger AMT
• Municipal interest is generally federal-tax-exempt; capital gains stay fully taxable
• Bond insurance covers credit risk only, not interest rate risk, and today runs in the AA range
• TEY = municipal yield ÷ (1 − tax bracket); higher brackets get more value from tax exemption