Municipal bonds are a type of bond that is very popular among investors looking for tax-free income. The interest they earn is not subject to federal taxes. In this tutorial, you will learn the basic facts about municipal bonds. You will read about the following topics:
WHAT ARE MUNICIPAL BONDS?
Municipal bonds (nicknamed munis) are bonds issued by states, cities, counties and various districts to raise money to finance operations or to pay for projects. The projects they finance include hospitals, schools, power plants, office building, airports, etc. Municipalities levy taxes as their first source of revenue. When they need more money (such as when they overspend), they may turn to issuing bonds as a way to raise extra money.
Individual investors purchase the majority of municipal bonds. These bonds are usually issued in $5,000 face-value denominations or multiples of $5,000. They mature in anywhere from one to fifty years. Like other bonds, they may also be bought at a discount. For example, an investor may buy a $5,000 bond for only $4,000. At maturity, he or she will receive the original $5,000.
Municipals are considered relatively safe from default despite some adverse notoriety in past years. After they have been issued, they can be sold to other investors on the secondary market through exchanges or on the over-the-counter market.
Municipal bonds come in a variety of forms. We will discuss those forms below.
FORMS OF MUNICIPAL BONDS
The two main forms of municipal bonds are general obligation and revenue. These two types are distinguished according to whether they are secured or unsecured (these distinctions will be briefly discussed later).
General obligation bonds (GO bonds) are unsecured municipal bonds that finance municipal operations. They have maturities of 10 years or more. The creditworthiness of the issuing city or state is the only "guarantee" they provide. GO bonds finance projects that do not produce revenue.
The municipal issuer repays the bonds with funds raised by fees or property sales. If the issuer is unable to pay, it may turn to taxation to guarantee interest and principal payments.
Generally, all the individual bonds in a GO bond issue have the same maturity date.
REVENUE BONDS
The revenues generated by the projects they fund secure revenue bonds. Such revenues include tolls, fees and lease payments. For example, a city may issue revenue bonds to pay for a new stadium. It will pay bondholders their interest and principal from the stadium's revenues. Default will occur if revenues are not high enough to pay bondholders. In this case, payments to bondholders will be deferred. Endowments donated by companies or individuals who want to help finance a particular project partially secure some revenue bonds.
Revenue bonds involve higher risk than GO bonds because of the possibility that the projects financed may not bring in enough revenue to pay bondholders. However, these bonds also pay higher yields. Their maturities are usually serial. This means that individual bonds of one whole issue mature on different dates.
Read below to learn about the different types of revenue bonds.
TYPES OF REVENUE BONDS
The most common types of revenue bonds are:
Industrial revenue bonds, which finance public projects.
Project notes, which are short-term debts that finance public housing construction.
New Housing Authority bonds, which finance low-income housing.
Special tax bonds, which are backed by excise taxes such as those on cigarettes and alcohol.
Special assessments on those who will benefit directly from a particular project may also back them.
Double-barreled bonds, which are backed by both revenue and the municipality's creditworthiness.
Anticipation notes, which allow work to begin on a project early while the municipality awaits revenue from other sources. These are technically not bonds because their maturities are too short (one month to one year) to qualify them as bonds.
We will now cover some properties of municipal bonds.
CHARACTERISTICS OF MUNICIPAL BONDS
Municipal bonds may be secured or unsecured. To be secured means to be backed by collateral, as are revenue bonds. To be unsecured is to be without collateral. Investors who choose unsecured bonds must trust the issuer's creditworthiness. As mentioned before, general obligation bonds are of this type.
Many municipals, especially revenue bonds, have an interesting additional feature: They may be insured by outside agencies. These insurers guarantee that they will pay bondholders their interest and principal if the issuers default. Both individuals and issuers may carry insurance. Individuals must have at least $50,000 in three or more issues before they can buy insurance.
Two well-known municipal bond insurers are the Municipal Bond Insurance Association (MBIA) and the American Municipal Bond Assurance Corporation (AMBAC). Large commercial banks also sometimes guarantee bonds.
Insured bonds are rated higher than non-insured bonds, but pay lower interest rates.
Finally, we come to the most popular feature of municipal bonds -- their tax-exemption.
TAX-EXEMPTION
Most municipal bonds are free of federal income taxes on interest distributions. Also, most are free of state and local taxes in the state in which they are issued. These features make them hugely popular among small investors. However, capital gains are not exempt from taxes. Gains on municipals sold at discount are considered interest and not capital gains.
The Tax Reform Act of 1986 created classes of bonds that are subject to federal income tax. Still, most investors and issuers use the term "municipal bond" to refer to the tax-free variety. Tax-free bonds are those that benefit the public. Taxable bonds are used in the private sector.
If you want to compare the returns on a municipal bond with those of a taxable bond, you can use an easy formula to help you.
You can use a figure called the taxable equivalent yield to calculate how much you would need to earn on a taxable bond to equal what you are earning on a municipal bond. Taxable equivalent yield is calculated with this formula:
| Taxable Equivalent Yield = | Tax-free yield |
| 1- Tax Rate |
Here is how it works. Imagine you pay federal taxes at 28 percent. Now suppose that you are considering buying a municipal bond that earns 6% interest. To calculate how much you would need to earn on a taxable bond to equal your 6 percent, enter the numbers:
| Taxable Equivalent Yield = | 6 | = | 6 | = 8.33% |
| 1- 0.28 | | 0.72 | |
You would have to earn 8.33% on a taxable bond to equal your 6% municipal bond. Many investors use taxable equivalent yields to help them choose which bonds to buy.
This concludes our introduction to municipal bonds.
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