General Characteristics of Municipal Securities
Before diving into specific bond types, you need to understand the fundamental features that all municipal securities share: what they are, how they're quoted, how interest works, and the role of the legal opinion.
What Are Municipal Securities?
- Municipal securities are debt securities issued by states, cities, counties, and other political subdivisions, including school districts, water authorities, housing authorities, and transportation agencies
- The defining feature: interest on most municipal bonds is exempt from federal income tax
- If the investor resides in the issuing state, interest is often exempt from state and local tax as well (called triple tax-free)
- Municipal securities are exempt from SEC registration under the Securities Act of 1933, Section 3(a)(2), but they are still subject to anti-fraud provisions
- The Municipal Securities Rulemaking Board (MSRB) writes rules governing dealers and municipal advisors; FINRA and the SEC enforce those rules (the MSRB has no enforcement authority)
Think of it this way: The tax exemption is the main reason investors buy munis. Because interest is tax-free, issuers can offer lower coupon rates than comparable corporate bonds and still attract buyers. Investors in higher tax brackets benefit most.
Exam Tip: Gotchas
- Municipal bonds are exempt from SEC registration, but NOT exempt from anti-fraud rules. The exam tests this distinction frequently.
- The MSRB writes the rules, but FINRA and the SEC enforce them. The MSRB itself has no enforcement authority.
Method of Quotation
Municipal bonds can be quoted two ways:
| Quote Type | How It Works | Example |
|---|---|---|
| Yield basis (basis price) | Quoted as a yield to maturity or yield to call | "3.50" means the bond yields 3.50% to maturity |
| Dollar price | Quoted as a percentage of par | "98" means 98% of par value ($4,900 per $5,000 bond) |
- Serial bonds are typically quoted on a yield basis
- Term bonds and bonds trading at a specific dollar price are quoted as a percentage of par
- Most municipal bonds trade on a yield basis; this is the default
Exam Tip: Gotchas
- Yield basis is the default for munis. If a question mentions a municipal bond quote without specifying the method, assume yield basis.
- Dollar price quotes use the bond's $5,000 par value (not $1,000 like corporates). A quote of "98" on a muni means $4,900.
Interest Rate, Payment Periods, and Denominations
- Most municipal bonds pay interest semiannually (every 6 months)
- Standard denomination is $5,000 par value (or multiples thereof), different from corporate bonds at $1,000
- Interest rates are set at issuance and are typically fixed, though variable-rate and auction-rate municipals also exist
- Accrued interest on municipal bonds is calculated using the 30/360 day count convention (each month counts as 30 days, each year as 360 days)
- Interest accrues from the last payment date up to, but not including, the settlement date
Exam Tip: Gotchas
- Municipal bonds use $5,000 par value (not $1,000 like corporates). This affects dollar price calculations.
- Munis use the 30/360 day count, the same as corporate bonds. Government and agency bonds use the actual/365 (actual/actual) convention instead.
Diversity of Maturities
Municipal bonds come in several maturity structures:
| Structure | Description | Typical Use |
|---|---|---|
| Serial bonds | Multiple maturity dates within a single issue; each maturity has its own coupon rate | Most common for GO bonds |
| Term bonds | All bonds mature on a single date; may have a mandatory sinking fund | Often associated with revenue bonds |
| Serial and term combination | An issue with both serial maturities and one or more term maturities | Flexible structure |
| Balloon maturity | A serial issue where a large portion of the principal matures on the final date | Used when a large repayment is expected later |
Exam Tip: Gotchas
- Serial bonds = multiple maturity dates; term bonds = single maturity date. These are often confused on the exam.
- Balloon maturity is a type of serial bond, not a term bond. The key difference is that most principal comes due on the final date rather than being spread evenly.
The Legal Opinion
- A legal opinion (bond counsel opinion) is provided by a qualified bond counsel, a law firm specializing in municipal finance
- The legal opinion addresses two things:
- The legality of the issuance (was the bond properly authorized?)
- The tax-exempt status of the interest (is the interest exempt from federal income tax?)
- Bonds sold without a legal opinion are called ex-legal and are generally less marketable
- The legal opinion is printed on or attached to the bond certificate (or referenced in the official statement)
Exam Tip: Gotchas
- The legal opinion does NOT guarantee creditworthiness or investment safety. It addresses only legality and tax status. A common wrong answer pairs the legal opinion with credit quality.
- Ex-legal bonds are legal to trade but less marketable. The absence of a legal opinion makes buyers less confident, reducing demand.