Municipal Government Bonds (Munis)
Municipal bonds are issued by the states of the United States, U.S. territories and possessions, such as Puerto Rico, and by any government agency that is not federal, including cities, counties, schools, municipal authorities, and so on. Munis (aka municipals), as municipal bonds are often called, are issued for immediate funds and to finance specific projects. Municipals are sold by auction. However, the number of new municipal issues has declined significantly since the passage of the 1986 Tax Act.
Overview of the Taxation of Municipal Bonds
The primary advantage of municipal bonds for the investor is that the interest in most states is exempt from federal taxes, and from state and local taxes, if the bond was issued by a municipality within the taxpayer's state—triple exempt. Munis issued by the territories and possessions are triple exempt, also. Additionally, municipal interest is also exempt from the new 3.8% Medicare surtax assessed on investment income, starting in 2013. Because of the tax exemption, and because of their relative safety, municipal bonds generally pay the lowest interest rates.
Most states, including California and New York, tax municipal bond interest if the municipal bond was issued from another state. Some states, such as Utah, exempt interest from out-of-state bonds if their own bonds are tax-free in the issuing state. A few states tax all municipal bond interest, including Illinois, Iowa, Nebraska, Oklahoma, and Wisconsin. No state may tax bonds issued by United States territories because they are barred from taxing it by federal law.
The interest earned by municipal bonds is generally tax-free because the law has allowed it. In fact, the United States Supreme Court, in 1895, ruled that it was unconstitutional for the federal government to tax state and municipal bonds, but a 1988 ruling by the same court has reversed that decision. Nonetheless, the federal government has not taxed municipal interest, since the state and its municipalities would have to pay a higher interest rate if the interest was taxable.
Note, however, that any capital gains earned by selling municipal bonds in the secondary market place, before their maturity, are taxable. Likewise, capital losses from the sale of municipal bonds are deductible from capital gains and up to $3000 of excess losses can be deducted annually from other income. Unexpected capital gains may also arise from mutual funds holding municipal bonds. Even though the interest earned is generally tax-free, fund managers will often be forced to sell to pay for redemptions by investors.
Another important consideration in the taxation of municipal bonds is that, even if the interest is tax-free, the amount of this interest is used to determine the taxation of Social Security income. Hence, the municipal bondholder may be subject to additional tax because of this provision. Tax-free interest may also increase the income that is used to determine other exemptions or tax credits, leading to more taxes overall:
- a qualifying relative can only claim an exemption for a dependent if more than ½ of her support, which includes tax-free interest received by the dependent, is provided by the relative
- the premium tax credit for Obamacare health premiums is determined by household income, which also includes tax-free interest
There are 2 types of municipal bonds, however, whose interest is subject to taxation. One type is the Build America Bonds, which were issued in 2009 and 2010 to stimulate the economy out of the recession created by the financial crisis of 2007-2009. Issuers and insurers of Build America Bonds received federal subsidies so that a higher interest rate could be offered on the bonds to promote their marketing; hence, the interest earned by these bonds are taxable. Another type of bond that may be taxable are private activity bonds, which are bonds to finance private activities which are being promoted by the municipality in the hope of receiving more taxes through the hopefully greater economic activity generated by the financed project, such as sports stadiums. Under the regular tax system, the interest from private activity bonds may be tax-free if the issuer satisfies certain tax rules, but, in all cases, this interest must be added back to income under the alternative minimum tax system. So, interest from private activity bonds will certainly be taxable for those taxpayers subject to the AMT, which is why private activity bonds are also called AMT bonds.
To compare the yields of munis with other securities, the taxable equivalent yield (TEY) is computed, which equates the tax-free yield with the taxable yield. Because the tax benefit is only significant to wealthy individuals and organizations, such as corporations and insurance companies that pay taxes, these entities constitute the market for municipal bonds. Pension funds, charities, and other tax-exempt organizations can get greater yields from taxable securities, since, for them, the taxable equivalent yield is equal to the yield.
Municipal Securities Rulemaking Board (MSRB)
Created by Congress in 1975 as an amendment to the Securities Exchange Act, the MSRB is a self-regulatory organization subject to SEC oversight to oversee the municipal securities industry. The MSRB is composed of 15 members from 3 groups: securities firm representatives, bank dealer representatives, and public members, with 5 members from each group for equal representation on the board. The MSRB enacts standards of professional practice, rules of fairness, regulations of broker-dealers, and record-keeping requirements, which municipal brokers or dealers must follow. However, MSRB enactments do not apply to issuers of municipal securities, since most issuers are governments or their agencies. Although municipal securities are exempt from registration under the Securities Act of 1933, issuers are still subject to the antifraud provisions of the federal securities act.
Legal Opinion and the Bond Attorney
Municipal bonds are not subject to the Securities Acts of 1933 or 1934, so to give potential investors confidence in the issue and to pay lower yields, the issuer will generally hire a municipal bond attorney, who is an independent attorney that specializes in bond evaluations, to give a legal opinion about the issue. The legal opinion contains the terms of the offering, any call provisions, any limitations of the issuer's taxing authority, ensures that the physical bond certificate is proper, and that the debt is legally binding on the issuer. Not all munis are issued with a legal opinion, and these are designated as ex-legal.
A very important part of the legal opinion is the issue's tax-exempt status, and whether it satisfies all requirements for that status. One risk with municipal bonds is that it may be determined later—by the IRS, for instance—that the issue does not satisfy all requirements for tax-exempt status, in which case, the bondholders will be subject to unanticipated taxes.
The bond attorney does not, however, write the official statement.
Municipal bonds are not subject to the Trust Indenture Act of 1939, and, thus, are not required to have an indenture, but many of them do, especially revenue bonds. Generally, the indenture contains the following provisions:
- a promise to maintain rates sufficient to pay expenses, and bond interest and principal when due;
- any call provisions, including call dates and premiums;
- insurance to cover the facility financed by the bond issue;
- to maintain an independent auditor;
- to issue regular financial reports;
- and whether more bonds can be issued for the project.
All municipal bond issues will have an official statement, which contains basic information that an investor would need to know:
- the amount of money required to purchase the issue, which in most cases will be $5,000,
- the source of revenue that backs the issue,
- the registrar and paying agent,
- and how the proceeds of the issue will be used,
- its tax exempt status,
- and how and when interest will be paid, and the interest rate.
Municipal Bond Insurance
Some municipal bonds, when they are not backed by the taxing power of the municipality, are insured. In the event of a default, the insurance company pays the par value of the bond. Bonds are insured by the issuer, because they lower the risk and raise the credit rating of the bonds, so the issuer can pay a lower interest rate than uninsured bonds.
Investors can also purchase insurance for their bond holdings, if they have at least 3 different issues with a net value greater than $50,000.
The number of municipal bond insurance companies has decreased since the passage of the 1986 Tax Act. Currently, there are only 3 municipal bond insurance companies that offer this insurance:
- MBIA Insurance Corporation (MBIAC), the largest municipal bond issuer.
- Ambac Financial Group, Inc., a wholly owned subsidiary of Citicorp.
- Financial Guaranty Insurance Company.
Types of Municipal Bonds
Municipal bonds can be classified according to maturities:
|Notes||short||1 month - 1 year|
|Bonds||short||1 - 6 years|
|intermediate||6 - 19 years|
|long||≥ 20 years|
However, most municipals are classified according to the issuer, by how the funds will be used, or by the source of the backing of the bond. Most bonds have a single source for backing the bond, but double-barreled bonds have 2 sources of backing, although such bonds are rare nowadays.
Entire issues also can be classified according to maturities. Term bonds mature in a single year; serials mature in successive years; and balloon serials are serials where most of the issue matures in a single year. How the maturities of an issue is set is determined by the projected cash flows of the project being financed.
General Obligation Bonds (GOs)
General obligation bonds are obligations of a government or its agency, and backing for the bond issues from the issuer's unlimited taxing power. State bonds are generally based upon income, sales, or excise taxes, and city, county, and school district bonds are based upon ad valorem real estate taxes. GO bonds can also be classified according to the taxing power of the issuer. Unlimited tax G.O. bonds are issued by a government or agency with unlimited taxing powers and have the lowest yield, whereas limited tax G.O. bonds are issued by an entity whose taxing powers are restricted in some way, such as by state law, voter approval requirement, or constitutional limitations, and have slightly higher yields. however, general obligation bonds are unsecured, and the municipality may not have to pay interest or principal in a Chapter 9 bankruptcy.
Limited and Special Tax Bonds
Limited and special tax bonds' safety is derived from a specific tax, such as a gasoline tax or a special assessment. These bonds are not quite as secure as GOs, because they are based upon a specific tax; nonetheless, they are generally safe. Most of these bonds are financed by excise and ad valorem taxes, and by special assessments, which are taxes assessed against a specific group that benefits from the improvements financed by the tax.
Authorities and agencies, created by state governments to perform specific functions, issue bonds for specific needs, such as the construction of a building, that generally have the power to levy fees for their services, such as the operation of water and sewers, or they have contractual arrangements with a government entity that provides payments for services. Revenue bonds, which are the most common type of municipal bonds, are not backed, however, by the taxing power of the government entity.
Most revenue bonds are callable, and can have term, serial, or balloon maturities.
Before most revenue bonds are issued, an independent agency does a feasibility study of the project, with projections of required expenses and revenues. After the project is operating, revenues generated are first used to pay operating and maintenance expenses. Anything left over is considered net revenue, and is allocated thus:
- To pay current interest and principal of the issued bonds.
- To fund a reserve to provide for up to 2 years of payments of interest and principal.
- To fund a reserve for the maintenance of the project.
- To expand the project or retire bonds.
Industrial Revenue Bonds (IRB) or, Industrial Development Bonds
Industrial revenue bonds finance the construction of a commercial facility for a private user. A local community creates an industrial development authority that can borrow money by issuing municipal bonds. The facility is then leased backed to the corporate guarantor. Though the safety of the bond is dependent on the creditworthiness of the corporation, and not the municipality, frequently, the corporation has superior credit.
Capital Appreciation Bonds (CABs)
Capital appreciation bonds are municipal zero coupon bonds, which are issued at deep discounts to their face value, and pays its interest at maturity by paying the face value of the bond.
Prior to the Tax Reform Act of 1986, almost all municipal bonds were exempt from federal taxes, and from state and local taxes if the bond was issued by the state of the taxpayer. However, the Tax Reform Act of 1986 allowed only public purpose bonds to be tax-exempt, and could be issued in any quantity. These are bonds that are issued to primarily benefit the public. However, if the bond benefits private parties more than 10%—a private purpose bond—then it is generally taxable. Private purpose bonds, also known as alternative minimum tax bonds, or AMT bonds, can be designated as tax-exempt, but there is a volume cap, and the interest paid by these bonds are tax preference items that must be included in calculating the alternative minimum tax.
Because wealthy people are generally subject to the alternative minimum tax, and because they are the main buyers of most municipal bonds, since the tax exemption benefits them the most, they generally shun AMT bonds. This lowers the demand for AMT bonds, which increases the amount of interest they pay compared to other municipal bonds. Thus, AMT bonds are a good investment for people not subject to the alternative minimum tax.
Zero-Coupon Convertible Bonds
Some municipal bonds are first issued at a discount as zero-coupon bonds that are converted later into regular interest-paying bonds. Before the conversion, interest is earned as the difference between the par value of the bond and the discount price. Afterwards, bond pays interest semiannually, just as most other bonds.
Taxable Municipal Bonds: Private and Public Purpose Bonds
The Tax Reform Act of 1986 has made some municipal bonds taxable, if part of the proceeds is used to fund private activities or to provide private entities loans. The Tax Reform Act distinguishes between private and public activity bonds.
A public purpose bond (aka public activity bond, essential purpose bond) is a municipal bond that is exempt from federal taxes, if less than 10% of the proceeds are used to finance private projects, or if less than the lesser of 5% of the proceeds or $5,000,000 is used for loans to nongovernmental entities. Some bonds, such as those for sports stadiums, trade, and convention centers, or large issues of industrial development bonds of $1,000,000 or more are specifically prohibited from being tax-exempt.
A private purpose bond (aka private activity bond, nonessential purpose bond) is a bond where the limits have been exceeded, and, thus, become taxable. Some permitted private activity bonds are generally tax-exempt if the bondholder does not owe the alternative minimum tax. Permitted issues are limited by volume caps, however, unless they are issued for 501(c)(3) organizations, such as hospitals, and colleges and universities, or for airports, docks, wharves, and government-owned solid-waste disposal facilities.
Various short-term notes are issued by municipalities for current income that will be paid off by expected future revenue. Hence, many of these notes are called anticipation notes.
Issued by municipalities to finance current operations. Municipal notes, usually in $25,000 denominations, have maturities that range from 60 days to about a year, when interest and principal are paid by tax or bond revenues.
Anticipation Notes: TAN, BAN, RAN, TRAN, GAN, SAAN
Tax anticipation notes (TAN) are issued by cities for current income, and are paid off when tax revenues are collected. Bond anticipation notes (BAN) are issued in anticipation of bond revenue that will come later because the municipality wants to combine several projects into 1 bond issue, or because poor market conditions delay the issuance of bonds. Revenue anticipation notes (RAN) are issued in anticipation of revenue from the project that it finances, such as a toll road or a sewer system. Tax and revenue anticipation notes (TRAN) are paid by future taxes and revenue. Grant anticipation notes (GAN) are paid by federal grants, and state aid anticipation notes (SAAN) are paid off by aid received from the state.
Deficient Disclosures by Municipal Bond Issuers
As this article notes, many issuers of municipal bonds do not regularly issue financial statements, such as annual financial reports or reports of material changes, such as an impending credit ratings downgrade. Hence, many bondholders are not aware of any trouble that may be developing. According to DPC Data, 1 of 4 nationally recognized municipal securities information repositories, from examinations of filings during 1995 - 2006, 50% failed to file a required financial report 1 or more times, 25% missed 3 or more years of disclosures, and many bonds issued in 2006 had deficient disclosures. The trend of delinquent disclosures appears to be growing. Delinquent exposures seem to increase with the age of the issue, and also for the riskiest municipal bonds, such as revenue bonds. Problem disclosures extends to all size issuers, all categories of municipal bonds, and to all sectors of the country.
The SEC cannot, by law, enforce any action to require disclosure, but can only take action in cases of fraud. Furthermore, the SEC excludes issuers with less than $10 million of outstanding debt from disclosure requirements, and issuers of debt with terms equal to or shorter than 9 months do not have to file an annual disclosure. The SEC does require, however, that no new bonds can be issued unless the issuer is current with the most recent 5 years of required filings.
Some interesting statistics cited:
- There were 54,000 municipal issuers with outstanding debt;
- 25,000 of these issue debt every 2 years.
Governments Never in Default Pay More Interest Than Companies - Bloomberg.com
This article from Bloomberg (10/28/2009) also illustrates that municipalities pay higher interest rates because of the lack of disclosure. Specifically, it points out that:
- Municipalities and even states, such as the state of California, are paying higher yields on Build America Bonds than comparable corporate bonds, even though corporate bonds are 98 times more likely to default. Because the income from Build America Bonds are taxable, like corporate bonds, they can be more directly compared.
- Many municipal issuers do not allow public bidding on their bonds and therefore pay a higher interest rate. Many of these deals are negotiated privately, where the issuer's agents often receive gifts and money from the financial advisers who are doing the deal. The advisers, in turn, charge hefty fees for their services to the municipality.
- A new online information source, the Electronic Municipal Market Access (EMMA), is now available for investors of municipal bonds, provided by the Municipal Securities Rulemaking Board, which governs dealers that underwrite and sell municipal bonds in the market. EMMA lists all of the available disclosures provided by municipal issuers of bonds.
Taxes on Out-of-State Municipal Bonds Ruled Unconstitutional
Kentucky's Court of Appeals has ruled—and the Kentucky Supreme Court has declined to review it—that a state cannot tax the interest on out-of-state municipal bonds any differently than in-state issued bonds because it violates the U.S. Constitution's Commerce Clause. The state's taxing authorities say that it will reduce the ability of the state and its municipalities to raise money for public interests, but I don't see how that would necessarily follow. In fact, it might lower their costs because there would be a larger market for their bonds.
Source: Tax Report: Kentucky Suffers Setback in Muni-Bond Tax Case - WSJ.com
- Defaults for municipal bonds increases during recessions and depressions, since tax revenue is lower. From 1929 to 1937, the default rate for municipal bonds was 1.8%.