Deepen your understanding of municipal bonds, their features,
and their role in the financial landscape.
As of 2010, there are about $2.8 trillion in municipal bonds outstanding. Of this amount, $1 trillion are directly owned by US households. Another $1 trillion is held by bond funds, money market funds, and closed-end funds. The rest are held by banks, insurance companies, and the like. Foreigners, corporations, and central banks do not buy municipal bonds in a big way because these types of investors do not benefit from U.S. tax-exempt interest.
Tax-exempt means that, in the opinion of legal counsel, the interest you earn on the security is exempt from federal income taxes and from personal income taxes. Investors should consult their brokers or other municipal bonds or notes and taxable investment alternatives.
Municipal bonds and notes can be an important part of a diversified investment portfolio. Because bonds and notes typically have a predictable stream of payments of principal and interest, many people invest in them to preserve and increase their capital, or to receive dependable interest income. Additionally, the interest earned on municipal securities typically is exempt from federal and state income taxes.
It is important to remember that investment objectives, and the best strategies for achieving those objectives, depend on an individual investor’s particular circumstances. The tax advantage investors reap from tax-exempt securities will vary according to their income level.
Tax-free interest. The primary reason people buy municipal bonds is that the interest received from municipal bonds is tax-free with regard to U.S. federal income tax. Additionally, if the bonds are issued in your state of residence, the interest is tax-free of your state’s income taxes as well in most US states. For instance, a California resident would not pay California state income tax or federal income tax on the interest received from California State General Obligation bonds.
Most municipal securities may be sold prior to maturity with the assistance of a brokerage firm. If an investor sells a municipal security prior to maturity, he or she may receive more or less than the original price depending on prevailing market interest rates, supply and demand, and perceived credit quality of the securities, among other variables. In addition, investors should consult a tax advisor for any tax implications.
The interest earned on most GO bonds issued by the States is exempt from federal and state income tax, subject to rules relating to tax-exempt bonds set forth in the Internal Revenue Code. However, because of the programs funded by these bonds, it is not certain the bonds meet all of the tax rules so the State’s bond counsel will not provide its normal opinion that interest on these bonds is exempt from federal income taxation.
When an issuer sells a new issue, it is referred to as a primary market sale. In a new issue, all of the terms are set, including the price and interest rates, and the securities are sold to investors, with the issuer receiving the proceeds of the sale. The initial sales commission paid to broker-dealers is paid by the issuer, such as the issuing State from the proceeds. A retail investor who would like to participate in a primary market transaction must have an account with, and purchase the securities through a brokerage firm serving as one of the issuer’s underwriters or selling group members.
A secondary market transaction does not involve the issuer, but is a transaction between two investors – a buyer and a seller. Secondary market transactions involve a brokerage firm which acts either as a liaison between the buyer and seller, or as a buyer or seller itself. Buyers pay sales commissions to brokerage firms to compensate them for their services in facilitating the transaction. Market conditions, such as prevailing interest rates, supply and demand, and credit quality, among other variables, determine the price, which likely will differ from the original price.
As a general rule, the higher your tax bracket, the greater the benefit from tax-free interest. For instance, a bond yielding 5% tax-free is most beneficial to a person in the 35% federal tax bracket as opposed to someone in the 15% tax bracket. The person in the highest tax bracket receives a significant benefit from the tax-exempt interest. For a person in the 35% tax bracket, to equal 5% tax-free interest, he or she would need to earn 7.7% taxable interest from CDs or corporate bonds. Learn more about tax-equivalent yield.
Historically, municipal bonds have had a strong record of safety compared to corporate bonds. Certain types of municipal bonds have been historically much safer than others. No state has defaulted on State general obligation municipal bonds since the Civil War. The key difference in risk can be found between general obligation bonds and revenue bonds. Safety is a component of the risk of the project being financed, the economic characteristics of the area, the tax backing of the bonds, and many other factors. Investors need to understand the default characteristics of municipal bonds. In addition, investors should understand the recovery rates when municipal bonds do default. Recovery rates are the percentage of the money owed that the bondholder ultimately recovers after the bonds default. This is important to know because all is rarely lost when a municipal bond defaults. For instance, with the Orange County default in 1994, the bondholders were paid back 100 cents on the dollar with interest within 18 months of the default.
Revenue bonds are backed by the revenues expected to be generated from the project being financed. Hospitals, housing projects, buildings to be leased to governments, sewer systems, power generation, all generate revenue after the initial project is financed and built. With revenue bonds, the revenues generated from the project is the money used to pay the interest and principal on the bonds. For instance, if a bridge authority issues revenue bonds to build a toll bridge, the tolls collected when drivers drive over the bridge is the money that will be used to pay the interest and ultimately the principal back on the bonds. Unlike general obligation bonds, the power of the bridge authority is limited in the practical sense: If the expected toll bridge traffic is not there, tolls will need to be increased to compensate for the revenue shortfall. Unfortunately, if tolls are increased by too big a factor, the revenues would decline even more as people take alternate routes to avoid the tolls. Other types of revenue bonds such as bonds issued by water systems, sewer systems, power generation and distribution systems are considered to be more essential in nature. Not only can the utilities that issue the bonds increase the prices of these sewer, water, and power, but the ability for an homeowner to choose an alternative to the public utility is limited. As such, the safety of revenue bonds issued by issuers providing essential services are considered to be superior in credit quality to non-essential services.
With general obligation bonds, the issuer is using its taxation power to back the interest payments and ultimate repayment of the bonds. For instance, when a state, city, county, township, school district issues general obligation bonds, the entire taxation power of the issuing government is backing the bonds. This mean that if the municipality runs into any financial difficulty, it will need to raise taxes in any form that it can to the point that bondholders can be paid back. Many states, including California, have it written into their constitutions that bondholders of state-backed debt must be paid before any money can be used for any other obligation. In California, bondholders of the state are the second in line after the needs of K-12 education. Local municipalities back their general obligation bonds with property taxes as this is usually the sole method of taxation available to most small towns. If a local government has a financial problem, it must raise its property taxes to the point that it can service the municipal bonds that it has issued. If it does not, a judge can issue something called a writ of mandamus that can force the municipality to raise taxes and pay bondholders. School districts issue general obligation bonds backed by one or multiple towns that constitute a school district. In a nutshell, a general obligation bond means that the issuer is obligated to pay the interest and principal on the bonds from any source of revenue it can get its hands on. This gives GOs a certain degree of safety compared to revenue bonds.
Duration is the time it takes for an investor to be repaid the price for a bond by the bond’s total cash flows. For example, suppose the current price of a bond is $970, maturity is in three years, the annual coupon payment is $50, and the current market interest rate is 7%. The present worth of the coupon payments and payment of the $1,000 principal is $2,686.23. The duration, calculated by dividing the present worth by the current price is: $2,686.23 / $970 = 2.77 years Bonds that pay coupon interest will always have a duration less than maturity. Zero coupon bonds, with no coupon payments, have a duration equal to maturity. Using duration, it’s possible to approximate how much a bond’s price is likely to rise or fall when interest rates change. As interest rates increase, a bond’s price decreases. Duration measures how quickly a bond will repay its price. The longer it takes, the greater exposure the bond has to changes in the interest rate environment. Therefore, the longer the duration, the higher is the interest rate risk (as opposed to default risk). Here are some of factors that affect a bond’s duration: Time to maturity: Consider two bonds that each cost $1,000 and yield 5%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less risk. The longer the maturity, the higher the duration, and the greater the interest rate risk. Coupon rate: A bond’s payment is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration, and the lower the interest rate risk. Knowing the duration of a bond, or a portfolio of bonds, gives an investor an advantage in two important ways: Speculating on interest rates: Investors who anticipate a decline in market interest rates, as a result of, for instance, a stimulative rate cut by the Federal Reserve, would try to increase the average duration of their bond portfolio. Likewise, investors who expect the Fed to raise interest rates would want to lower their average duration. Matching bond selection to your risk: When selecting from bonds of different maturities and yields, duration allows you to quickly determine which bonds are more sensitive to changes in market interest rates, and to what degree.
Municipal bonds are bonds issued by states, local governments, school districts, power districts, and many other forms of government to raise money for projects dedicated to the public interest. Schools, bridges, hospitals, power plants, and many forms of public infrastructure are built from the money raised by issuing municipal bonds.
BondView here to help you make the most of your municipal bond investments. If you have any questions, need assistance, or would like to provide feedback, simply reach out today.