4.5 Municipal Bonds

Municipal bonds ("munis") are debt securities issued by state and local governments and their agencies. Their primary advantage is tax-exempt interest income.

Types of Municipal Bonds

General Obligation (GO) Bonds

Backing: Full faith, credit, and taxing power of issuer

Voter Approval: Usually required

Uses: Schools, roads, government buildings

Risk: Generally lower (broad tax base)

Analysis: Evaluate tax base, economy, management

Unlimited Tax GO Bonds: Issuer can raise taxes as needed to pay debt. Limited Tax GO Bonds: Tax increases capped at certain level.

Revenue Bonds

Backing: Revenue from specific project or source

Voter Approval: Usually NOT required

Uses: Toll roads, airports, hospitals, utilities, stadiums

Risk: Higher than GO (single revenue source)

Analysis: Evaluate project feasibility, revenue projections

No Taxing Power: If the project fails to generate revenue, bondholders may not be paid.

Comparison

GO Bonds: Backing, tax revenues; Voter Approval, required; Risk, lower; Yield, lower; Analysis Focus, issuer's economy

Revenue Bonds: Backing, project revenues; Voter Approval, usually not; Risk, higher; Yield, higher; Analysis Focus, project viability

Short-Term Municipal Securities

TANs: Tax Anticipation Notes; Backed by expected tax receipts

RANs: Revenue Anticipation Notes; Backed by expected revenues

BANs: Bond Anticipation Notes; Backed by proceeds of future bond issue

TRANs: Tax and Revenue Anticipation Notes; Backed by both taxes and revenues

These are money market instruments issued to cover short-term cash flow needs.

Tax Treatment

Federal Tax

Interest Income: Exempt from federal income tax

Capital Gains: Taxable

Original Issue Discount: Taxable as ordinary income

State and Local Tax

In-state bond: Usually exempt ("double tax-free")

Out-of-state bond: Usually taxable

NYC triple exempt: Exempt from federal, NY state, AND NYC taxes

Tax-Equivalent Yield Formula

To compare municipal bonds to taxable bonds:

Tax-Equivalent Yield = Municipal Yield / (1 - Tax Rate)

Example: A 4% municipal bond for an investor in the 35% tax bracket:

- Tax-equivalent yield = 4% / (1 - 0.35) = 4% / 0.65 = 6.15%

- A taxable bond would need to yield 6.15% to match the after-tax return

Who Benefits Most From Munis?

12% tax bracket: Tax-equivalent yield (4% muni) 4.55%

22% tax bracket: 5.13%

32% tax bracket: 5.88%

35% tax bracket: 6.15%

37% tax bracket: 6.35%

Higher tax brackets benefit more from tax-exempt income.

Alternative Minimum Tax (AMT)

Some municipal bonds are subject to the Alternative Minimum Tax:

Essential function bonds: Generally AMT-free

Private activity bonds: Often subject to AMT

Industrial development bonds: Often subject to AMT

Private Activity Bonds: Finance private projects (stadiums, airports) but issued by municipalities.

Municipal Bond Analysis

GO Bond Analysis

Debt per capita: Debt burden on residents

Tax base: Property values, economic diversity

Budget management: Balanced budgets, fund balances

Economic trends: Population, employment, income

Pension obligations: Unfunded liabilities

Revenue Bond Analysis

Coverage ratio: Revenues divided by debt service

Rate covenant: Commitment to raise rates if needed

Flow of funds: Priority of debt service payments

Project feasibility: Realistic revenue projections

In Practice: How Investment Advisers Apply This

Client suitability:

- Munis are most beneficial for high-tax-bracket investors

- Consider state residence for double/triple tax-free benefits

- NOT appropriate for tax-advantaged accounts (IRA, 401k), no benefit from tax exemption

Portfolio construction:

- Compare tax-equivalent yield to taxable alternatives

- GO bonds for conservative muni investors

- Revenue bonds for higher yield with more risk

- In-state bonds for maximum tax benefit

On the Exam

The Series 65 exam tests your understanding of:

1. GO vs. Revenue bonds: Taxing power vs. project revenues

2. Tax treatment: Federal exempt; state depends on residency

3. Tax-equivalent yield formula: Municipal Yield / (1 - Tax Rate)

4. Who benefits: High-tax-bracket investors

5. AMT: Private activity bonds may be subject to AMT

Common formats include tax-equivalent yield calculations and GO vs. revenue bond characteristics.

Key Takeaways

- GO bonds backed by taxing power; revenue bonds backed by project income

- Municipal interest is federal tax exempt

- In-state bonds are usually state tax exempt also ("double tax-free")

- Tax-equivalent yield = Municipal Yield / (1 - Tax Rate)

- Higher tax brackets benefit more from municipal bonds

- NOT appropriate for tax-advantaged accounts (no tax benefit needed)

- Private activity bonds may be subject to AMT

- Revenue bonds have higher risk and yield than GO bonds