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
| Feature | Description |
|---|---|
| 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
| Feature | Description |
|---|---|
| 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
| Feature | GO Bonds | Revenue Bonds |
|---|---|---|
| Backing | Tax revenues | Project revenues |
| Voter Approval | Required | Usually not |
| Risk | Lower | Higher |
| Yield | Lower | Higher |
| Analysis Focus | Issuer's economy | Project viability |
Short-Term Municipal Securities
| Type | Description | Backed By |
|---|---|---|
| TANs | Tax Anticipation Notes | Expected tax receipts |
| RANs | Revenue Anticipation Notes | Expected revenues |
| BANs | Bond Anticipation Notes | Proceeds of future bond issue |
| TRANs | Tax and Revenue Anticipation Notes | Both taxes and revenues |
These are money market instruments issued to cover short-term cash flow needs.
Tax Treatment
Federal Tax
| Feature | Treatment |
|---|---|
| Interest Income | Exempt from federal income tax |
| Capital Gains | Taxable |
| Original Issue Discount | Taxable as ordinary income |
State and Local Tax
| Scenario | State/Local Tax Treatment |
|---|---|
| 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?
| Tax Bracket | Tax-Equivalent Yield (4% Muni) |
|---|---|
| 12% | 4.55% |
| 22% | 5.13% |
| 32% | 5.88% |
| 35% | 6.15% |
| 37% | 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:
| Bond Type | AMT Status |
|---|---|
| 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
| Factor | What to Evaluate |
|---|---|
| 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
| Factor | What to Evaluate |
|---|---|
| Coverage ratio | Revenues ÷ 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:
- GO vs. Revenue bonds: Taxing power vs. project revenues
- Tax treatment: Federal exempt; state depends on residency
- Tax-equivalent yield formula: Municipal Yield / (1 - Tax Rate)
- Who benefits: High-tax-bracket investors
- AMT: Private activity bonds may be subject to AMT
Expect 2-3 questions on municipal bonds. 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
The interest on municipal bonds is generally:
An investor in the 35% tax bracket is considering a municipal bond yielding 4%. What is the tax-equivalent yield?
General obligation bonds are backed by:
4.6 Bond Pricing & Yields
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