Municipal bonds are debt obligations issued by public entities that use the loans to fund public projects such as the construction of schools, hospitals, and highways.
Reasons to consider municipal bonds
- Interest income generally federally tax exempt
- Low level of default risk relative to other bond types
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In general, municipal bonds fall into one of two categories—general obligation or revenue bonds. This categorization is based on the source of their interest payments and principal repayments. However, within these categories, a municipal bond can be structured in different ways, with each variation offering different benefits, risks, and tax treatments. While most investors think of municipal bonds as tax-exempt investments, this may not always be the case, as there are instances where the income generated by a municipal bond may be taxable. For example, a municipality may issue a bond that does not qualify for federal tax exemption, resulting in the income generated by that bond being subject to federal taxes. As a result of these different treatments, it's important to consider all aspects of a municipal bond before making a purchase, rather than relying on its broad categorization.
General obligation bonds (GOs)
General obligation bonds are issued by governmental entities but are not backed by revenues from a specific project, such as a toll road. Some general obligation bonds are backed by dedicated taxes on property, while others can be payable from general funds. The latter types of bonds are often referred to as "backed by the full faith and credit" of the governmental entity. While in many instances, "general obligation" means that the issuer has unlimited authority to tax residents to pay bondholders, there are cases in which the issuer or governmental entity may have limited or no taxing authority.
Principal and interest payments for revenue bonds are secured by revenues generated by the issuer or by certain taxes such as sales, fuel, or hotel occupancy taxes. The only exception is when a municipality issues bonds as a conduit issuer. In those cases, while the municipality is the issuing entity, a third party is responsible for payments of both interest and principal. To learn more about conduit issuers, please see our section on Conduit bonds.
The issuers of revenue bonds are generally:
- Non-profit organizations (501(c)( 3)).
- Private-sector corporations (such as hospitals and universities).
- Entities that provide a public service (such as utilities and public transportation authorities).
Some municipal bonds are insured by policies written by commercial insurance companies. The insurance policy is intended to provide for the insurer to pay principal and interest payments to bondholders in the event the issuer defaults. Investors should take into account the creditworthiness of both the insurer and the issuer when considering insured bonds.
Taxable municipal bonds
The interest on some municipal bonds is taxable because the federal government will not subsidize the financing of activities that do not provide significant benefit to the public. Bonds issued to finance things like stadiums, replenishment of a municipality’s underfunded pension plan, or investor-led housing are a few examples of issues that would not qualify for federal tax exemption. Build America Bonds (BABs) are a recent category of taxable municipal bonds, introduced in the wake of the 2008 financial crisis. The advantage for issuers is that they receive a 35% federal rebate on interest costs for these bonds. BABs only subsidize an issuer’s borrowing cost. There is no implied backing from the federal government.
Zero-coupon municipal bonds are issued at an original issue discount, with the full value, including accrued interest, paid at maturity. Interest income may be reportable annually, even though no annual payments are made. Market prices of zero-coupon bonds tend to be more volatile than bonds that pay interest regularly.
Original-issue discount bonds
These are municipal bonds issued at a price below face value (par) which qualify for special treatment under federal tax law. The difference between the issue price and the face value is treated as tax-exempt income rather than as capital gains if the bonds are held to maturity.
Market discount bonds
When a municipal bond is purchased for less than its face value (par) in the secondary market, this is often referred to as a discount. Bonds may be sold at a discount for a variety of reasons, including changes in interest rates, changes in market conditions, a change in the issuer's credit rating, or other events impacting the issuer. These bonds can also be referred to as market discount bonds, particularly when the amount of the discount exceeds a certain calculated amount specified under the Internal Revenue Code.
Pre-refunded bonds result from the advance refunding of bonds that are not currently redeemable. Once issued, the proceeds are placed in an escrow account set up to generate enough cash flow to pay interest and principal up to a specified call date. The goal is typically to provide present-value savings to the issuer, but in some cases can be used to change the indenture on the bonds. The escrow account is most often funded with U.S. Treasuries (although other instruments are sometimes used), in which case the pre-refunded bonds are considered relatively safe.
Escrowed-to-maturity (ETM) bonds
Bonds are "escrowed to maturity" when the proceeds of a refunding issue are deposited in an escrow account for investment in an amount sufficient to pay the principal and interest on the issue being refunded. In some cases, though, an issuer may expressly reserve its right to exercise an early call of bonds that have been escrowed to maturity. The escrow account is most often funded with U.S. Treasuries (although other instruments are sometimes used), in which case the escrowed bonds are considered relatively safe.
Housing bonds are securities backed by mortgages and mortgage loan repayments. Although not reflected as part of a traditional "call schedule," these bonds can be called at any time from the prepayment of principal on the housing authority's underlying mortgages, and therefore display as continuously callable and subject to extraordinary redemption (ER) provisions.
Municipal notes are short-term debt obligations which typically mature within a year or less, but may mature within two or three years. Municipalities issue notes to generate stable cash flow while they wait for other expected revenues. The types of municipal notes depend on the source of future cash flow, such as Tax Anticipation Notes (TANs), Revenue Anticipation Notes (RANs), and Bond Anticipation Notes (BANs).
These are revenue bonds issued by municipal agencies called "conduit issuers" that are third-party entities that act on behalf of the actual borrowers, typically private nonprofit (501(c)(3)) entities. Conduit bonds may be issued for projects such as nonprofit hospitals, housing developments, colleges and universities, transportation hubs, student loan programs, and public works projects. The third-party borrower—not the issuing conduit agency—is responsible for interest payments and principal repayments. The issuing agency generally is not obligated to use any other source to repay the bonds if the conduit borrower fails to make loan repayments. So, unless the official statements indicate otherwise, investors in conduit bonds should not view the issuing governmental agency as a guarantor on conduit bonds.
In general, the interest you earn from your tax-exempt municipal securities is exempt from federal income tax and in some cases, state or local income tax, depending on whether you are a resident of the state that issued the bond.
While municipal bonds' coupons are often lower than those offered by similarly rated corporate bonds, the fact that interest income is tax-free can result in the yields being comparable, or even higher in some cases.
Additionally, if you purchase original-issue discount bonds and hold them until their maturity date, those investments may receive special tax treatment under federal tax law. In these cases, the difference between the bond’s issue price (the discounted rate) and its face value would be considered tax-exempt income rather than capital gains.
Although a municipal bond may be referred to as tax-exempt, there could be federal and state tax consequences when you buy, sell, or own the bond. Please see our section on Tax risks for more details.
While municipal bankruptcies and defaults can and do occur, they have been relatively infrequent when compared to the corporate bond market. Historically, municipal bonds rated by a Nationally Recognized Statistical Rating Organization (NRSRO), and in particular general obligation bonds, have experienced very low default rates.
For example, according to a Moody's study of U.S. Municipal Bond Defaults and Recoveries, 71 total defaults occurred over the period 1970–2011, including only five general obligation bond issuers. At the end of 2011 approximately 9,700 issuers were rated by Moody’s. In addition, under federal bankruptcy laws, a municipality must be specifically authorized by its state to file for protection, and the rules that govern a bankruptcy differ from state to state.
Interest rate risk
Like all fixed income securities, the market prices of municipal bonds are susceptible to fluctuations in interest rates. If interest rates rise, market prices of existing bonds will typically decline, despite the lack of change in both the coupon rate and maturity. Bonds with longer maturities are generally more susceptible to changes in interest rates than bonds with shorter maturities.
Many municipal bonds carry provisions that allow the issuer to call or redeem the bond prior to the actual maturity date. An issuer will typically call bonds when prevailing interest rates drop, allowing the entity to re-issue bonds at a lower borrowing cost. In this circumstance, the action makes reinvestment less desirable for the holder. Some municipal bonds, including housing bonds and certificates of participation (COPs), may be callable at any time regardless of the stated call features. In some cases, bond issuers will call bonds to modify an indenture through a new offering. Investors should also be aware of special or extraordinary redemption provisions. These are provisions that give a bond issuer the right to call the bonds due to a one-time occurrence, such as a natural disaster, interruption to a revenue source, unexpended bond proceed, or canceled projects.
The vast majority of municipal bonds are not traded on a regular basis; therefore, the market for a specific municipal bond may not be particularly liquid. This can be attributed to the large number of municipal issuers and variety of securities. With limited exceptions for some large more actively traded issues, the chances of finding a specific municipal bond in the secondary market at any given time are relatively small. According to the Municipal Securities Rulemaking Board (MSRB), it is much more common to identify basic characteristics of a municipal bond in which an investor is interested in investing (e.g., state, creditworthiness, maturity range, interest rate, or yield, market sector, etc.) and then to make a choice from a set of municipal securities that meet those criteria. Selling prior to maturity can present a challenge for municipal bond investors due to the fragmented and thinly traded nature of the market.
Revenue sources risk
With revenue bonds, the interest and principal are dependent on the revenues paid by users of a facility or service, or other dedicated revenues including those from special taxes. In general, the consumer spending that provides the funding or income stream for revenue bond issuers may be more vulnerable to changes in consumer tastes or a general economic downturn than the income stream for general obligation bond issuers. "Essentiality" is a key investor consideration for a project financed with revenue bonds. For example, a facility that delivers fundamental or essential services, such as water and sewer, may be more likely to have dependable revenues through multiple economic cycles. When evaluating revenue bonds, it is important to consider:
- The overall economic health of the region or customer base and the impact it might have on the entity's ability to sustain its revenues.
- The exact source of the revenues that will service and repay the debt. Is the bond solely dependent upon one source of revenue or is a larger entity standing behind the issue?
- The entity's track record of operational effectiveness through multiple economic cycles. Is there a track record of solid growth attracting more customers or taxpayers from more diverse sources?
- The legal provisions that may be in place to protect the bondholder, such as rate covenants and debt service reserve funds.
- The competence of financial management of the entity. Has its credit rating been maintained or strengthened over a period of time? How has it weathered previous economic downturns? How much debt does it have? How much of its cash flow is committed to paying down debt vs. investing in new projects or supporting services of value for the community?
Credit and default risk
Credit risk is the risk that the issuer will default or be unable to make required principal or interest payments. Despite the fact that many municipal bonds have high credit ratings, there is a risk of default in any bond investment.
While municipal bonds can offer attractive effective yields and can be a way to generate tax-free income, they may not be right for investors in every tax bracket or for every type of account. For instance, a portion of the income you receive may be subject to the federal alternative minimum tax, even if that income is classified as tax free. Also, if you sell a municipal bond, the proceeds from that sale may be subject to capital gains or other types of taxes.
De Minimis Tax Risk
If you purchase a municipal bond in the secondary market at a (market) discount to the revised issue price, you will have to pay tax on the difference when the bond is redeemed. The revised issue price is par for a bond originally issued at a price greater than or equal to par. For a bond issued below par (an original issue discount bond), the revised issue price will be the original price plus the accredited discount. This market discount can be taxed as either a capital gain or ordinary income. Capital gains are taxed at the current capital gains tax rate and ordinary income is taxed at your marginal tax rate, which can be close to twice as high as the capital gains rate for a taxpayer in the highest federal tax bracket. The De Minimis rule states that if the market discount (revised issue price less the purchase price) is less than 0.25 multiplied by the number of full years to maturity after acquisition, the market discount is treated as a capital gain for tax purposes. If the market discount is above the De Minimis threshold, it will be taxed at your ordinary income tax rate. Please see Tax and Liquidity Considerations for Buying Discount Bonds (PDF) to learn more.
If you are looking at a 20 year municipal bond with a revised issue price of 99 and nine complete years left until maturity, the de minimis discount is 0.25 x 9 years = 2.25. You then subtract the 2.25 from the revised issue price to get the de minimis threshold, which in this example is 96.75 (99 – 2.25). This is the lowest price the bond can be purchased for in order for the market discount to be treated as a capital gain. If the price of the discount bond is purchased at a price below 96.75, the market discount will be subject to ordinary income tax. So, if you purchased this bond for 92.75, ordinary income tax will apply on the entire amount of the difference (99 - 92.75) when the bond is redeemed at par, since 92.75 is less than 96.75. Please see De Minimis Dilemma (PDF) for more details.
Finally, it's important to remember that tax laws may change. The favorable tax conditions that existed at the time you purchased a bond may either have been phased out or no longer available to investors in your tax bracket. Please consult your tax advisor before purchasing any security.
As with all bonds, investors run the risk that inflation will diminish the purchasing power of a municipal bond's principal and interest income.
There can be no assurance that bonds validly issued will not be partially or totally repudiated by the issuing state or municipality, should that be deemed reasonable and necessary to serve other important public purposes.
Not all risks can be quantified in a bond's prospectus or offering circular. A type of risk called "special event risk," lawsuits or significant legal changes, another community’s public works project, unusual weather, an economic downturn, or other events could impact the issuer's ability to meet their financial commitments.
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Municipal Securities Rulemaking Board (MSRB)
Find the official financial statements and notices of material events for a specific bond. Visit the MSRB site and enter the CUSIP number or issuer's name.
Municipal Bonds: Understanding Credit Risk (PDF)
Learn more about assessing credit risks when purchasing municipal bonds in this SEC investor bulletin.
Preliminary official statements
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