Municipal Securities
Unlike corporate bonds, which are fully taxable, municipal securities offer a major tax advantage: their interest is generally exempt from federal income tax. This makes them a frequently tested topic on the SIE exam.
Municipal Bond Basics
- Issued by state and local governments (cities, counties, school districts, public authorities)
- Interest is generally exempt from federal income tax
- May be double-exempt (federal + state) if the investor resides in the issuing state
- May be triple-exempt (federal + state + city) in certain jurisdictions (e.g., New York City)
- Standard par value: $5,000 (not $1,000 like corporates)
- Private activity bonds may be subject to the Alternative Minimum Tax (AMT)
Think of it this way: Municipal bonds are the tax-free option in the bond world. Investors in higher tax brackets benefit the most because the tax savings are worth more to them. A 5% tax-free yield beats a 6% taxable yield for someone in the 37% bracket.
Exam Tip: Gotchas
- Municipal bond par value is $5,000 (not $1,000 like corporate bonds). This is a common trap on the exam.
General Obligation (GO) Bonds
GO bonds are the safer of the two main municipal bond types:
- Backed by the full faith, credit, and taxing power of the issuing municipality
- Repaid from ad valorem (property) taxes and general revenues
- Require voter approval in most cases
- Subject to statutory or constitutional debt limits
- Considered safer because the municipality can raise taxes to pay bondholders
Think of it this way: GO bonds are backed by the government's power to tax. As long as people live in the city and own property, the city can collect taxes to pay you back. That is why GO bonds are considered safer.
Revenue Bonds
Revenue bonds are backed by specific project income rather than taxing power:
- 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 to assess the project's viability
- Typically offer higher yields than GO bonds from the same issuer (more risk = more reward)
- Key covenant: rate covenant, where the issuer pledges to maintain rates/fees high enough to cover debt service
Exam Tip: Gotchas
- GO bonds require voter approval; revenue bonds do NOT. Revenue bonds are repaid from project income, so taxpayers do not need to approve them.
- Revenue bonds have higher yields because they carry more risk (no taxing power as backup).
GO vs. Revenue Bonds Comparison
| Feature | GO Bonds | Revenue Bonds |
|---|---|---|
| Backing | Taxing power (ad valorem taxes) | Specific project revenue |
| Voter approval | Usually required | Not required |
| Risk level | Lower | Higher |
| Yield | Lower | Higher |
| Key covenant | Debt limit | Rate covenant |
| Feasibility study | Not required | Required |
Other Municipal Securities
- Industrial Development Revenue Bonds (IDRBs): issued by municipalities to finance private facilities; backed by the private corporation, NOT the municipality
- Taxable municipal bonds: issued for purposes that do not qualify for tax exemption (e.g., pension funding); interest is federally taxable
- Build America Bonds (BABs): taxable municipal bonds where the federal government provides a subsidy to the issuer
Exam Tip: Gotchas
- IDRBs are backed by the private corporation using the facility, NOT by the municipality that issued them. The municipality's name is on the bond, but the corporation carries the credit risk.
Short-Term Municipal Obligations
| Type | Full Name | Anticipates |
|---|---|---|
| TANs | Tax Anticipation Notes | Future tax revenue |
| RANs | Revenue Anticipation Notes | Future non-tax revenue |
| BANs | Bond Anticipation Notes | Proceeds from a future bond issue |
| CLNs | Construction Loan Notes | Construction loan proceeds |
Municipal Bond Disclosures
- The Official Statement (OS) is the municipal equivalent of a prospectus
- Provides material information about the issuing entity and the bond terms
- Municipal bonds are exempt from SEC registration under the Securities Act of 1933
- However, they are NOT exempt from antifraud provisions
- The Municipal Securities Rulemaking Board (MSRB) regulates municipal securities dealers, NOT the issuers themselves
- Issuers must provide continuing disclosure under SEC Rule 15c2-12
- MSRB Rule G-17 requires fair dealing in municipal securities transactions
Exam Tip: Gotchas
- Municipal bonds are EXEMPT from SEC registration, but NOT exempt from antifraud provisions. Fraud is never allowed, even for exempt securities.
- The Municipal Securities Rulemaking Board (MSRB) regulates dealers, NOT issuers. The MSRB has no authority over state and local governments that issue the bonds.