Municipal Bonds 101

Introduction

Municipal bonds (referred to as “munis”) play a very important role in the national economy by providing financing for public projects and allowing municipalities to create and maintain important infrastructure projects.

The tax advantages of municipal bonds make them very popular with investors, but the large number of bond issuers and types can be confusing to the uninitiated.  This lesson is designed to clear some of that confusion and provide a basic understanding of the characteristics, advantages, and risks of municipal bonds.

Characteristics of Municipal Bonds

Like all bonds, municipal bonds is a loan made by the bondholder to the issuer that will be paid back at a specified time (the maturity date) and pays a specified rate of interest (the coupon rate).  Most municipal bonds mature from 1 to 30 years but some bonds have been issued for longer periods up to 100 years.  Municipalities also issue short term instruments (less than thirteen months to maturity) that include notes and commercial paper.  Municipalities also issue floating-rate and zero coupon securities.  Municipal bonds are typically issued in denominations and multiples of $5,000.

Some municipalities issue serial bonds, which are bond issues that have different maturity dates at regular intervals.  This allows the issuer to spread out the repayment of principal.  A typical serial issue may have bonds maturing from years 1 to 20.

Many municipal bonds have sinking funds and /or call provisions.  It is important for investors to know about any early redemption provisions in a bond, as these features can greatly impact the potential return on the investment.

Some municipalities offer bonds that give the bondholder the right “put” (sell the bond back to the issuer) the bond at par at a specified date prior to maturity.  Some municipal bonds are insured in order to reduce credit risk.  In the event that the municipality defaults on the bond, an insurance company pays the issuer’s obligation.

General Obligation Bonds

General obligation bonds (GOs) are backed by the full faith and credit of the issuer and are backed by the municipality’s ability to tax.  Local municipalities generally depend mostly on property taxes to service their debt, while state governments depend more on sales and income taxes.

Revenue Bonds

Revenue bonds are issued to support revenue generating projects and facilities and are secured solely by the revenue of the project or facility that they are financing.  Some revenue bonds, however, have had their credit rating enhanced with insurance.

Most municipalities do not have a profit motive for borrowing money.  Instead, they issue debt to fund facilities and projects to benefit the citizens of their community.  Because of this, many feel that the project or facility should be paid over time by all of the benefactors of the project, including those that will benefit in the future, and that the debt should be paid over the useful life of the facility or project.  This pay-as-you-use philosophy supports the issuance of revenue bonds as these bonds are paid off by the revenues received from the project and not the entire municipality.

Double-Barreled Bonds

Some bonds are a hybrid of GOs and revenue bonds in that they are secured by both revenue and the full faith and credit of the municipality.  These bonds are known as double-barreled bonds.

The Issuers

Municipal bonds are issued by state and local governments, either directly or through an authority.  An authority is a separate governmental entity expressly created to issue bonds and/or manage an enterprise.  Authorities can either issue bonds for themselves or for separate qualified non-government parties.

Municipal bond issuers include (in order of size):

  1. Local governments: cities, towns, villages, parishes, districts, and counties;
  2. State authorities;
  3. Local authorities;
  4. State governments; and
  5. Public colleges.

Uses of Municipal Debt

Municipal bonds usually finance long-term capital projects rather than day-to-day operating expenses. The most typical uses include:

  • Education
  • Healthcare
  • Water, sewer, and gas
  • Transportation
  • Single family housing
  • Pollution control
  • Multifamily housing
  • Public power
  • Airports
  • Student loans
  • Nursing homes
  • Industrial development
  • Economic development
  • Waterfront and harbors
  • Solid waste/resource recovery
  • Utilities
  • Colleges

The Primary Market

The new issue primary market for municipal bonds is enormous: more than 15,000 new issues were underwritten in 2009 that accounted for nearly $475 million.

There are two kinds of municipal bond underwritings: competitive and negotiated.  In a competitive sale, underwriters submit sealed bids to the issuer.  The winning bidder buys the bonds from the issuer at the bid price and reoffers them to investors at a higher price.  In a negotiated underwriting, the underwriter negotiates the price in which it pays the issuer for the securities and the price at which it sells the issue to investors.  The underwriter receives his fee as the gross spread between what he pays the issuer and the price he receives from investors.

Out of the gross spread, the underwriter has to pay certain expenses that include:

  • Salaries
  • Legal fees
  • Advertising
  • Insurance
  • Meeting expenses
  • Travel
  • Commissions
  • CUSIP fee
  • MSRB fees
  • Cost of carry
  • Miscellaneous overhead

The issuer is usually responsible for paying the following expenses:

  • Advisory fees
  • Rating agency fees
  • Issuer’s counsel
  • Insurance
  • Printing

For most large offerings, the underwriter forms a syndicate with other underwriting firms, with the winning underwriter normally acting as the lead underwriter.

The Secondary Market

Once a new issue of municipal bonds has been successfully sold to investors, they begin trading on the secondary market.  Municipal bonds trade in an over-the-counter market where trades are executed through municipal securities dealers.  The secondary market provides liquidity for investors in the event that they choose to sell the bond prior to maturity.  According to SIFMA, Municipal bonds trading volume averaged $21.8 billion and 43,383 trades a day in 2008.

Like all bonds, the prices of municipal bonds will fluctuate on the secondary market due to changes in the level of interest rates, changes in credit quality of an issuer, general economic conditions and other factors (see “How Bond Prices Fluctuate” in Bond Trading 101).

Investing in Municipal Bonds

Basics

The basics of bond investing that have already been covered in Debt Instruments 101 and 102, and Bond Trading 101 apply to municipal bonds.  However when comparing tax-free municipal bonds with taxable bonds, it is important to use the tax equivalent yield of the municipal bond when comparing yields.  The formula is: Tax Equivalent Yield=Tax-Free Yield/1-Tax Rate.

Risk Factors

Municipal bonds carry many of the risks that other fixed income investments share (see this lesson on bond risks).  Here we will focus on risks that are most important to municipal bond investors.

Credit Risk

Credit risk is of primary concern to municipal bond investors, and should be a primary driver of decisions involving the selection of bonds for the portfolio.  Credit risk is largely determined by the issuer’s credit rating (see the discussion of credit ratings in Debt Instruments 102), but there are a few additional factors that municipal bond investors should look at.

It is a widely held belief that general obligation bonds are safer than revenue bonds because of the “unlimited” taxing power of the issuer. In reality, the ability to tax is never truly unlimited.  A high quality revenue bond represent less risk than a lower credit GO.

Another dangerous assumption is that a larger municipality is safer than a smaller one.  The fact that New York City defaulted on their debt in 1975, Cleveland defaulted in 1978, and the Washington Public Power Supply System defaulted on $2.25 billion in bonds in 1983, argues against this theory.  However, there are some benefits to size.  The debt issues of larger municipalities are generally more liquid.

Municipal bond insurance has historically been popular with investors, but the current economic crisis has greatly weakened the financial strength and credit ratings of municipal bond insurers.  In 2007 there were seven triple-A rated insurers.  Currently, there are no insurer that is rated triple-A by all three major rating agencies.  The current credit ratings of the insurers that were triple-A rated in 2007:

Insurer Rating Moody’s/S&P/Fitch
AMBAC Assurance Corp. Caa2/CC/na
Assured Guaranty Corp. (AGC) Aa3/AAA/na
Assured Guaranty Municipal Corp. (Formerly FSA) Aa3/AAA/na
CIFG Assurance North America, Inc. na/na/na
Financial Guaranty Insurance Co. (FGIC) na/na/na
National Public Finance Guaranty Corp. (MBIA) Baa1/A/na
Syncora Guarantee (Formerly XL Capital Assurance) Ca/R/na

It is obvious that investors in insured bonds need to consider the ratings of the insurer as well as the issuer.

According to many bond analysts, the following types of municipal bonds should be avoided:

  • Municipalities with a population less than 10,000;
  • Municipalities with shrinking populations, tax bases, and deteriorating economics and property values;
  • Industrial development bonds (IDBs);
  • Hospital bonds; and
  • Nursing home developers.

It is prudent for investors to examine some of the same criteria that the rating agencies do when assessing a municipal bond.  If it is a general obligation bond, look at the wealth level of the average household, the diversification of industry in the municipality (it can be dangerous if the municipality depends on one industry like steel or auto making), and the total amount of debt outstanding.  When assessing revenue bonds, it is useful to look at the debt service coverage ratio, which measures the ratio of net operating income to total debt service.  For example, if an airport earns $60 million in a year when the debt service is $15 million, than the debt service coverage ratio is 4.  A ratio of two or more is considered acceptable.

Fortunately for municipal bond investors, defaults are a rare occurrence (corporate bonds are much more likely to default).  The risk of a credit downgrade is a more pressing concern.  It is interesting to note the default rate for municipal and corporate bonds up to 2007:

Rating Moody’s S&P
Muni Corp Muni Corp
Aaa/AAA 0.00% 0.52% 0.00% 0.60%
Aa/AA 0.06% 0.52% 0.00% 1.50%
A/A 0.03% 1.29% 0.23% 2.91%
Baa/BBB 0.13% 4.64% 0.32% 10.29%
Ba/BB 2.65% 19.12% 1.74% 29.93%
B/B 11.86% 43.34% 8.48% 53.72%
Caa-C/CCC-C 16.58% 69.18% 44.81% 69.19%
Investment Grade 0.07% 2.09% 0.20% 4.14%
Non-Investment Grade 4.29% 31.37% 7.37% 42.35%
All 0.10% 9.70% 0.29% 12.98%

Political Risk

Political risk is a factor of the political climate of a municipality.  It is essentially the risk that voters may pass referendums that could be damaging to the bondholders of the municipality.  Examples of such referendums include tax-limitation referendums or voters rejecting bond issues.

Taxation

This section will not cover all of the possible tax consequences of owning municipal bonds and is not intended to be tax advice.  As always, it is advisable to consult with a competent tax adviser about the tax consequences of any investment.

Interest

Most municipal bonds are exempt from federal income taxes, but there are some taxable municipal bonds, as well.  Tax-exempt municipal bonds are usually also exempt from state income taxes in the state that they are issued in, and local bonds may also be exempt from local income taxes.  For example, many New York city issued bonds are “triple tax free, “ being exempt from New York city, New York state, and federal taxes.

Federal tax-exempt bond interest must still be reported on federal tax returns, however, for informational purposes.

Capital Gains and Losses

While the interest income on most municipal bonds is not subject to federal income taxes, capital gains are taxable as they are for any security when they are sold.  The amount of gain or loss is the difference between the proceeds of the sale and what the cost basis of the bonds.

Currently capital gains are taxed as long-term or short-term.  Bonds that are held for more than 12 months qualify as long-term gains, and bonds that were held for 12 months or less are short-term.  Short-term gains are taxed as regular income, while long-term gains are taxed at a maximum of 15%.

Capital losses can be applied to offset gains, which must first be applied to gains of the same type (short-term or long-term).  Any remaining losses than then be used to offset ordinary income by up to $3,000 per year.  Any excess losses can be carried forward into future years.

Original Issue Discount and Premium

An original issue discount (OID) is a discount to par that may be applied to a new bond issue to increase its yield.  For example, a $5,000 bond may be purchased for $4,750 at issue, but the bond will pay $5,000 at maturity.  If the bond is tax exempt, the OID is treated as tax-exempt interest.  When an OID bond is sold, the OID increases the cost basis for calculating any capital gains or losses.  Similarly, if a bond is purchased as a new issue at a premium, that premium decreases the cost basis for calculating any capital gains or losses.

Early Redemption

If a tax exempt bond is called prior to maturity, it is taxed as if the bond was sold and there may be a short or long term capital gain or loss.

Borrowing Costs

Normally, the interest on debt used to purchase securities is tax deductible.  However, interest on indebtedness used to purchase a tax-exempt bond is not deductible if it is directly traceable to the purchase.  If borrowed funds used to finance the purchase of tax-exempt bonds and taxable bonds, the interest attributable to the taxable bonds is deductible.

Alternative Minimum Tax

Most tax-exempt municipal bond interest is also exempt from the Alternative Minimum Tax (AMT).  However, private activity bonds issued after August 7, 1986 are subject to AMT, with a few exceptions.

Short-Term Municipal Securities

Notes

Municipalities issue the following types of notes:

Tax-Exempt Commercial Paper

Commercial paper is a short-term money market instrument that is issued for periods of up to 270 days.  Municipalities issue commercial paper for the same purposes as notes.

Variable Rate Demand Obligations

Variable rate demand obligations (VRDOs) pay a variable interest rate that is adjusted at regular intervals (for example, daily, weekly, or monthly) and are redeemable at the holder’s option when the rate changes.

Build America Bonds

Build America Bonds (BABs) were created when President Obama signed the American Recovery and Reinvestment Act in February of 2009.  BABs are municipal bonds whose interest is taxable, but and the federal government subsidizes the municipalities’ interest payments. BABs have proven to be extremely popular with institutional investors, but not with for retail investors.  The reason for this is probably due to the fact that their interest is taxable, and they carry credit and liquidity risk.