Municipal Bonds
Municipal bonds are issued by state and local governments (cities, counties, school districts, public authorities). Their primary advantage is tax-exempt interest.
Types of Municipal Bonds
| Type | Backing | Security |
|---|---|---|
| General Obligation (GO) | Full faith and credit of issuer | Ad valorem (property) taxes |
| Revenue Bond | Specific project revenues | Tolls, user fees, lease payments |
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
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)
GO vs. Revenue Bonds Comparison
| Feature | GO Bonds | Revenue Bonds |
|---|---|---|
| Backing | Taxing power (ad valorem) | Specific project revenue |
| Voter approval | Usually required | Not required |
| Risk | Lower | Higher |
| Yield | Lower | Higher |
| Key covenant | Debt limit | Rate covenant |
Other Municipal Securities
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.
Insured Municipal Bonds
- Backed by a third-party insurance company that guarantees timely payment of principal and interest
- Insurance raises the bond's credit rating (typically to AAA)
- 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, typically AAA.
Tax Treatment
- 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.
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. A 4% muni equals a 7% taxable bond for someone in the 43% bracket, but only a 5.3% equivalent for someone in the 25% bracket.