Quick Answer
Municipal securities are debt issued by states, cities, counties, and other political subdivisions. Interest is generally exempt from federal (and often state/local) income tax, even though the securities themselves are exempt from SEC registration, not from anti-fraud rules. They trade on a yield basis or dollar price, pay interest semiannually in $5,000 minimum denominations, and carry a bond counsel's legal opinion covering only legality and tax status.
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 muni-securities exemption in the Securities Act of 1933, 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.
How Are Municipal Bonds Quoted?
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 ($980 per bond, or $4,900 per $5,000 block) |
- 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.
- A dollar price is a percentage of par, and municipal par is $1,000 per bond just like corporates. A quote of "98" is $980 per bond, or $4,900 on a $5,000 minimum block (five bonds).
How Do Interest Payments and Denominations Work?
- Most municipal bonds pay interest semiannually (every 6 months)
- Standard minimum denomination is $5,000 (or multiples thereof), which is five $1,000-par bonds; corporate bonds trade in single $1,000 bonds
- 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 par is $1,000 per bond, the same as corporates. What differs is the $5,000 minimum denomination. Do not treat the block size as one bond's par when computing a dollar price.
- Munis use the 30/360 day count, the same as corporate bonds and agency bonds. Only U.S. Treasury notes and bonds use the actual/actual convention.
What Maturity Structures Do Municipal Bonds Use?
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.
What Does the Legal Opinion Cover?
- 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.
What Should You Check on Exam Day?
- Munis are exempt from SEC registration, not from anti-fraud provisions
- The MSRB writes the rules; FINRA and the SEC enforce them
- Yield basis is the default quotation method; a dollar price is a percentage of par
- Municipal par is $1,000 per bond; the minimum denomination is $5,000
- Serial bonds = multiple maturities; term bonds = single maturity; balloon is a type of serial bond
- The legal opinion covers legality and tax status only, never creditworthiness