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.
| Feature | Description |
|---|---|
| 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.
| Feature | Description |
|---|---|
| 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
| Factor | GO Bonds | Revenue Bonds |
|---|---|---|
| Security | Full faith and credit | Specific revenue source |
| Taxing power | Yes | No |
| Risk | Lower | Higher |
| Yield | Lower | Higher |
| Voter approval | Yes | No |
| Use of funds | General purposes | 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:
- Federal income tax
- State income tax
- 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 ÷ (1 - 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
| Investor Tax Bracket | Benefit from Munis |
|---|---|
| 10-12% | Minimal—taxable bonds may yield more |
| 22-24% | Moderate benefit |
| 32-37% | Significant benefit |
Types of Municipal Revenue Bonds
| Type | Revenue Source |
|---|---|
| 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
| Risk Type | Description |
|---|---|
| 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
Which type of municipal bond is backed by the taxing authority of the issuer?
An investor in the 32% tax bracket is comparing a municipal bond yielding 4% to taxable bonds. What is the tax-equivalent yield of the municipal bond?
A California resident purchases a municipal bond issued by the state of California. The interest is most likely:
2.10 Money Market Instruments
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