Municipal bonds are debt issues by local governments, cities, towns, and other municpalities to fund projects such as highways, schools, and other facilities and infrastructure projects and impact the public good. By purchasing a municipal bond, you are giving the issuer the money to fund the project. In return, they will repay you the money and provide interest. There are two attractive features of municipal bonds: 1) most of them are Federal tax free and often state and local tax free; 2) they are relatively safe, backed by the issuing local or state government.
Tax Exemption of Municipal Bonds
Interest earned from municipal bonds is ordinarily federal-tax exempt. It is also state and local tax-exempt, provided that you are a resident of the issuing state (interest from bonds issued in certain territories, such as Puerto Rico are exempt in all states).
Municipal Bond Ratings
The most secure municipal bonds are those with are rated triple-A by either Moody's or Standard & Poor's (or both). Many municipalities which would not otherwise be able to get the highest credit rating are insured by FSA, MBIA or Ambac in order to get triple-A ratings. In the current environment, bond insurers are vulnerable to failure and the underlying credit ratings are suspect. The market is now pricing longer-term municipal bonds, including New York City and California general obligation bonds, as if they bear significant default risk. As a result, there is a significant opportunity to earn outstanding returns in municipal bonds at the moment; yet, these bonds are not without significant risk.
Types of Municipal Bonds
Tax-exempt municipal bonds can be broadly classified into two groups: general obligation and revenue bonds. The major distinction between the two is the manner in which they are secured - that is, where the money will come from to pay back the principal and interest of the loan to the bondholder.
General Obligation Bonds (GOs) are issued by a governmental unit that has the power to levy taxes. They are secured by the issuer's unconditional promise to pay promptly the semi-annual interest expense and principal when due. General obligation bonds mandate the issuer to use its ability to levy taxes for the repayment of the bonds. They finance public improvement projects that benefit the entire community, like streets, free-access highways, water systems, schools, police and fire stations.
Revenue Bonds are usually issued to finance a project or purpose that will generate income that can be pledged for repayment of the bonds, for example, water, sewer or electric power plants, airports, bridges, college dormitories and housing developments. Revenue generated by the project is used to pay the interest and principal of the bond.
There are also several types of municipal bonds that are not tax-free, including Taxable Municipal Bonds and Private Activity Municipal Bonds.
Ways to Invest In Municipal Bonds
Municipal bonds are ordinarily designed as long-term, long-dated investment. Many investors buy municipal bonds and hold them to maturity, taking the interest which is generally paid out semi-annually.
When purchasing a municipal bond directly, investors can purchase bonds either when issued or in the secondary market after issuance. Investors can buy bonds through dealers, banks and almost all brokerages. Bonds usually trade in $5,000 increments. When you buy when issued bonds, you are usually buying from a syndicate of sellers and when you buy bonds in secondary markets you are ordinarily buying from your dealer, bank or brokerage's inventory. The seller usually does not charges a commission, but their gain is built into the price in the form of a markup.
A trend may be beginning, led by Zions Direct, whereby individual investors can participate directly with bank syndicates in bidding for newly issued municipal offerings. Investors who participate in these offerings may find that they can achieve better rates than otherwise offered by a syndicate or through their brokerage's inventory.
Short-term investors have several, arguably less risky, alternatives to directly purchasing municipal bonds that allow equal access to the positive tax attributes of municipal bonds. These include:
Other alternatives which are significantly more risky than a straight purchase of municipal bonds involve investing in structured instruments secured by municipal bonds and bearing their tax characteristics (see closed-ended municipal bonds funds.
Comparing Municipal Bond Returns to Other Bonds and Investment Options
In order to determine the taxable equivalent of a tax-free municipal bond or a municipal product, divide the tax-free rate by the reciprocal of your cumulative federal and state tax obligations.
(Tax-free municipal rate) / (1 - Your federal tax rate - your state tax rate)
What to Look for in Municipal Bonds
The market for municipal bonds differs from state to state depending on the state's tax rate (high state and local taxes would tend to drive down municipal yields since they drive up taxable equivalents), demand within the state and supply. Therefore, it is always necessary to look at your state's market for municipals. The Bond Market Association produces a real-time ticker that shows where municipal bonds are trading at any given moment. See it here.
When you are purchasing a municipal bond, it is important to understand the yield to maturity. An municipal bond issue's yield to maturity is different from the coupon or interest that the bond pays semi-annually. It factors in any discounting or premium in the price versus par value and assumes that the bond trades to maturity (i.e., is not called on a call date).
Many municipal bonds are callable on certain dates before the maturity date at the issuers discretion. Ordinarily, the call will be at par, but it can also be at a slight premium. Before purchasing a bond, investors should understand the yield to call (bonds purchased at a premium will have a lower yield to call than yield to maturity; bonds purchased at a discount will have a higher yield to call than yield to maturity).
Avoiding Pitfalls with Municipal Bonds
Long dated municipals have a significant default risk that is not shared US Treasury Bonds and agency bonds. They also are less liquid, especially when purchased in smaller lots, and could incur a more pronounced decline in value in a rising interest rate environment than Treasuries as the supply is always more limited.
Many municipal bonds are insured by a third-party insurer, such as MBIA, Ambac or Berkshire. Always look at the credit quality of the underlying issuer as well as the insurer. Bonds insured by MBIA or Ambac may ultimately prove not to carry any third-party insurance.
Understand the tax consequences of the municipal bonds that you are buying. Avoid investing in municipal bonds where you cannot fully utilize the tax benefits (ie. municipals of other states). You may want to avoid municipals altogether if you live in a state without income tax or live outside the US (and are not a state taxpayer). If you have any concerns, you should consult with your accountant or tax adviser and be certain that interest produced by your municipal bond is free of federal, state and local taxes before you purchase.
You may be able to realize a loss on bonds that are purchased at a premium upon maturity or call. Likewise, you may need to realize a gain on bonds that are purchased at a discount upon maturity or call. Bonds purchased at a significant discount may be subject to special IRS rules making the discount fully taxable at ordinary income rates upon maturity.