2.9 Municipal Bonds

Municipal bonds ("munis") are debt securities issued by state and local governments to fund public projects. Their most attractive feature is tax-exempt interest, making them popular with investors in high tax brackets. The SIE exam tests your understanding of muni bond types, tax treatment, and risks.

What Are Municipal Bonds?

Municipal bonds are issued by:

- State governments

- City and county governments

- School districts

- Public utilities

- Transit authorities

- Other local government entities

The proceeds fund public infrastructure: schools, highways, hospitals, water systems, airports, and other community projects.

Two Main Types of Municipal Bonds

General Obligation (GO) Bonds

General obligation bonds are backed by the "full faith and credit" of the issuing government, including its taxing power.

Backed by: Government's taxing authority

Security: Property taxes, income taxes, sales taxes

Voter approval: Usually required

Risk level: Generally lower (taxing power is strong)

Key Point: GO bonds are only as safe as the government's ability and willingness to raise taxes to pay debt.

Revenue Bonds

Revenue bonds are backed only by the income generated from a specific project or source.

Backed by: Revenue from specific project

Examples: Toll roads, airports, hospitals, utilities

Voter approval: Usually not required

Risk level: Generally higher than GO bonds

Example: A toll bridge revenue bond is repaid from toll collections. If fewer people use the bridge than expected, revenue may be insufficient to pay bondholders.

GO vs. Revenue Bonds Comparison

Security: GO Bonds - Full faith and credit; Revenue Bonds - Specific revenue source

Taxing power: GO Bonds - Yes; Revenue Bonds - No

Risk: GO Bonds - Lower; Revenue Bonds - Higher

Yield: GO Bonds - Lower; Revenue Bonds - Higher

Voter approval: GO Bonds - Yes; Revenue Bonds - No

Use of funds: GO Bonds - General purposes; Revenue Bonds - Specific project

Tax Treatment of Municipal Bonds

Federal Tax Exemption

Interest on municipal bonds is generally exempt from federal income tax. This is their primary advantage.

State and Local Tax Exemption

Interest may also be exempt from state and local taxes if you live in the state where the bond was issued.

Triple Tax-Free

A bond is "triple tax-free" when interest is exempt from:

1. Federal income tax

2. State income tax

3. Local income tax

Example: A New York City resident who buys a New York City municipal bond receives interest that is exempt from federal, New York State, and New York City taxes - triple tax-free.

Tax-Equivalent Yield

Because muni interest is tax-free, investors must compare yields on an after-tax basis.

Tax-Equivalent Yield = Muni Yield divided by (1 minus Tax Rate)

Example:

- Municipal bond yield: 3%

- Investor's tax bracket: 35%

- Tax-equivalent yield: 3% / (1 - 0.35) = 3% / 0.65 = 4.62%

The 3% muni yield is equivalent to earning 4.62% on a taxable bond.

When Munis Make Sense

10-12% tax bracket: Minimal - taxable bonds may yield more

22-24% tax bracket: Moderate benefit

32-37% tax bracket: Significant benefit

Types of Municipal Revenue Bonds

Airport bonds: Landing fees, terminal rents

Hospital bonds: Patient fees, insurance payments

Toll road bonds: Toll collections

Utility bonds: Water, sewer, electric fees

Industrial development bonds: Corporate lease payments

Taxable Municipal Bonds

Not all municipal bonds are tax-exempt. Some purposes do not qualify for tax exemption:

- Sports stadiums

- Convention centers

- Private-purpose projects

- Certain refunding bonds

These taxable municipal bonds pay higher interest to compensate for the tax liability.

Alternative Minimum Tax (AMT)

Some municipal bonds are subject to the Alternative Minimum Tax (AMT):

- Private activity bonds may trigger AMT

- Essential-purpose bonds generally avoid AMT

- Investors subject to AMT should check bond details

Risks of Municipal Bonds

Credit risk: Issuer may default (rare for GOs, more common for revenue)

Interest rate risk: Prices fall when rates rise

Call risk: Many munis are callable

Liquidity risk: Less active secondary market than Treasuries

Legislative risk: Tax laws could change

Key Takeaways

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

- Municipal bond interest is generally exempt from federal tax

- Triple tax-free when held by a resident of the issuing state

- Use tax-equivalent yield to compare munis to taxable bonds

- Higher tax bracket = greater benefit from tax-exempt bonds

- Revenue bonds are riskier than GO bonds but offer higher yields