Municipal bond
Municipal bonds, or Munis for short, are bonds issued by city, county, or state governments for a variety of projects such as building schools, expanding highways, or constructing a new sewage system. Municipal bonds are normally exempt from state and local taxes, making them an attractive investment to men and women in the middle to higher tax brackets. Investors turn to municipal bonds, interest on which is free from federal taxes and in many cases state and local taxes as well.
Infrastructure in the US is generally financed through sub-national capital financing vehicles, termed municipal bonds, which encompass the issuance of bonds by state and local governments, their agencies and quasi-public bodies generically termed special districts. While the term comprises issuers other than municipalities, the first bond of this trail-blazing genre was issued in 1812 by New York City. This pioneering debt instrument was a general obligation bond, which meant that it was backed by the taxing power and tax revenues of the issuers.
Tax Reform Act of 1986 Increased Appeal of Municipal Bonds
Individual investor ownership in municipal bonds— either directly or through investments in bond funds—has increased dramatically since 1986. Today, over 75% of the outstanding supply of municipal bonds and notes (approximately $1.7 trillion) is owned by individual investors, as opposed to institutional and corporate investors. This percentage was less than 50% in 1986. Tax-exempt municipal bonds are the prudent investor’s path to lower federal income taxes. Certainly, municipal bonds have substantial appeal in their high spendable income—a direct result of federal income tax exemption; yet, tax exemption is only part of the story.
Also consider the following features of Municipal Bonds:
- High Credit Quality
The historic record of municipal bonds (as a domestic asset class) for meeting principal and interest payments on time is second only to that of the United States Government and Agency debt. During the Depression of the ’30s, municipal defaults as a group came to only about 2¢ on the dollar—and the vast majority of these situations were ultimately rectified. Typically, too, the worst offenders during this period are now subject to stringent state regulation and fiscal responsibility standards that arose as a direct result of the Depression experience.
- Adaptability
The form of municipal bonds makes it relatively easy, under most circumstances, to “custom-tailor” suggestions to meet specific portfolio needs. Since municipal bonds are generally sold with serial maturities (i.e., bonds maturing in consecutive annual installments), it is possible to find bonds that will pay back principal at otherwise unusual times like 3, 8 or 13 years. There are also vast possibilities for meeting individual investor cash needs; high coupon bonds selling at premiums are ideal income vehicles, while lower coupon issues, selling at discounts, can produce capital gains at pegged future dates. (Capital gains are, of course, subject to federal income taxation at applicable rates.)
- Diversification
The investment grade rating classification (i.e., suitable for fiduciary investment), covers well over 90% of outstanding municipal bonds. Such ratings, as denoted by two major investment services, Moody’s and Standard and Poor’s (S&P),
- Collateral Value
Bank loans from 80% to 90% of the value of collateralized municipals are not unusual. This, of course, is an important consideration in managing one’s own short-term cash positions.
- Marketability
The trading (or secondary) market in municipal bonds is an over-the-counter market, linking over 1,000 broker-dealer and dealer-bank offices across the country. Aggregate par volume of outstanding bonds exceeds $1.7 trillion. Widespread individual and institutional ownership has greatly expanded secondary market activity in recent years. As a general rule, marketability goes hand-in-hand with rating: “Aaa” (i.e., prime grade) bonds are somewhat better market vehicles than “Aa” or “A” securities, just as the latter have preference over “Baa” designations.
Some Additional Useful Facts Regarding Municipal Bonds and Municipal Bond Ownership
- Types of Bonds
There are two general classifications of municipal bonds
- General Obligation (G.O.) and
- Revenue bonds.
General Obligation bonds are normally backed by the “full faith and credit” and general taxing power of the issuer, and are generally regarded as the safest type of municipal debt. Revenue bonds, by contrast, are secured by specifically-pledged revenues; such revenues may be in the form of
- (1) earnings of the enterprise being financed [e.g., toll-road charges, waterworks receipts or hospital fees and charges] or
- (2) pledged taxes, fees or income that may be unrelated to the uses of bond proceeds [such as sales tax, gasoline tax or tuition fee secured bonds ] or
- (3) lease rental income, which is a regular means of public facility financing in many jurisdictions.
Private activity bonds are municipal bonds from issues where 10% or more of proceeds are used by private entities for qualified purposes. They generate interest income that is exempt from federal income taxes for personal tax returns. Qualified private activity bond interest is considered a preference item, however, and must be included in calculations of Alternative Minimum Tax (AMT) by individual taxpayers. Hence, if an investor has exposure to the individual Alternative Minimum Tax, he/she will pay the tax on private activity bond interest.
- Face Value
The face value (or “par value”) in which most municipal bonds are issued is $5,000. This is the sum that the contract promises to pay at maturity.
- Market Value
The market value of a municipal bond depends upon current market interest rate levels (that constantly shift) as related to the quality, coupon interest rate and maturity (and sometimes amount offered) of the specific bond. Municipal bonds are normally quoted on a yield-to-maturity basis. As we noted in the section on “Adaptability” (page 12), bonds will be priced at par, a premium or a discount depending on market levels.
- Pricing Premium and Discount Bonds
$10,000 City of Alpha 5% bonds due July 1, 2012 are offered for sale on July 1, 2002.
What General Precautions Should the Municipal Bond Buyer Observe?
While the circumstances surrounding any investment are unique to the needs of the individual investor, here are some general guidelines that many bond buyers find useful: Use funds for which there is no immediate need Vary maturity dates Select bonds from the four highest rating categories (AAA, AA, A, BB).
The chart below describes the low default history of municipal bonds rated by Moody’s and Standard & Poor’s as compared to corporate bonds.
CUMULATIVE HISTORIC DEFAULT RATES
[In percent]
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Moody’s S&P
Rating categories Muni Corp Muni Corp
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Aaa/AAA…………….. 0.00 0.52 0.00 0.60
Aa/AA………………… 0.06 0.52 0.00 1.50
A/A……………………. 0.03 1.29 0.23 2.91
Baa/BBB…………… 0.13 4.64 0.32 10.29
Ba/BB………………. 2.65 19.12 1.74 29.93
B/B………………….. 11.86 43.34 8.48 53.72
Caa-C/CCC-C….. 16.58 69.18 44.81 69.19
Investment Grade 0.07 2.09 0.20 4.14
Non-Invest Grade. 4.29 31.37 7.37 42.35
All…………………… 0.10 9.70 0.29 12.98
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Source. Moody’s, S&P.
Municipal Bonds Vs. Corporate Bonds
Municipal bonds are different from corporate bonds in several ways.
Most important, the income they generate is usually exempt from federal income taxes, whereas the income generated by U.S. Government or corporate bonds is not. In addition, if the investor lives in the state that issued the bond, the state income tax may be exempted. Local taxes (if any) may also be exempted.* Because municipal bonds are generally free from federal income taxes, they are referred to as “tax-exempt bonds.”
Another way that municipal bonds differ from corporate bonds is how they are retired at maturity. Corporate bonds are usually issued with “term” maturities, but many municipal bonds are issued with “serial” maturities. This means that the bond is issued with several maturity dates. A portion of the principal matures with each maturity date until the entire principal has been paid off.
The interest rate of a serial issue can also be different with each redemption date. As with some corporate bonds, many longer-term municipals may also include “call” provisions. This means that the issuer can choose to retire the entire value of the bond early, on the call date, and would likely do so if prevailing interest rates were lower than the bond’s coupon rate.
In addition, corporate bonds are usually issued in $1,000 amounts, but municipal bonds are usually offered in principal amounts of $5,000. Finally, municipal bonds are traded only on the over-the-counter market, whereas some corporate bonds are listed on exchanges.
*If the municipal bond is a “private purpose” bond, the income is taxable unless specifically exempted. Income from some bonds may be taxable under alternative minimum tax rules.
The Four Most Common Types: Understand Their Differences
- General Obligation Bonds
The most common type of municipal bond is called the general obligation (GO) bond. These bonds are not tied to a particular community project, and the issuer of the GO bond is obligated to make interest and principal payments on time, which makes them one of the least risky municipal investments.
Backed by the full faith and credit of the issuing government and its taxing power, GO bonds are considered very low risk and thus offer the lowest yields. These bonds must be approved by voters.
- Revenue Bonds
Backed only by the revenue that is expected to be generated by the facility being built and secured only by a specified revenue source such as highway tolls or airport fees. They are considered somewhat riskier than general obligation bonds and thus usually offer higher yields.
- Commercial Paper
Short-term debt issued by governments to meet cash-management needs, budget shortfalls, and the like. Typically they are backed by a bank letter of credit and carry maturities of less than nine months. The yields offered are generally low due to their short maturities.
- Private Activity Bonds
Used to fund private pursuits that qualify under federal law as having a tax-exempt status. They are considered riskier than revenue and general obligation bonds and thus offer higher yields.
Other types of bonds include special tax bonds and industrial revenue bonds, as well as variations on the general obligation bond.
How Municipal Bonds Can Work In Your Portfolio
Municipal bonds usually have a yield several percentage points below the yield on corporate bonds of comparable maturity. This means that a municipal bond can provide comparable after-tax yield as a taxable bond paying a higher interest rate.
If you are in a high tax bracket, the benefits of using municipal bonds in the bond portion of your portfolio could be impressive.
For example, if your income tax rate is 28%, a municipal bond paying 6% interest may actually be a better investment than a taxable bond paying interest at 8.3% (assuming that the municipal bond is free from federal and state income tax). Consult your tax advisor for more information.
Keep Potential Risks In Mind
With many thousands of municipal bond issues outstanding, keeping track of prices for each on a day-to-day basis is beyond the capabilities of news reporting organizations. Consequently, you won’t see specific municipal bond prices in a newspaper – you will need to consult a bond dealer if you are interested in a specific bond price. And even though municipal bonds are issued in increments of $5,000, the prices are quoted as if they were $1,000 issues.
As with the prices of other types of bonds, municipal bond prices react to changes in interest rates. Short- to intermediate-term bonds are less vulnerable to changing interest rates than longer-term issues, prices of which tend to fluctuate more as rates change.
Municipal bonds also pose credit risks – as became clear when Orange County filed for bankruptcy in 1994. Other risk variables are specific to municipal bonds, such as the potential for future changes in the tax law. (Currently, legislators are debating a proposed “flat tax” that could make municipal bonds less attractive to some investors.)
Some of these risks are lessened by purchasing shares of municipal bond funds, which are inherently diversified. Most municipal bond funds invest in the generally higher-quality, federally tax-free issues of state governments and municipalities. Professional management can save you the hassle of having to research and evaluate the thousands of individual bonds on the market. In addition, lower initial investment requirements help ease accessibility to municipal bonds.
Capital gains distributions from the fund may be taxable. In addition, some bond fund holdings may be subject to the federal alternative minimum tax. Investment return and principal value will fluctuate for municipal bond funds. When redeemed, shares may be worth more or less than the original cost.