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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. The primary advantage of municipal bonds for the investor is that they are 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 generally triple exempt, also. Because of the tax exemption, and because of their relative safety, municipal bonds generally pay the lowest interest rates.
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.
Municipals are sold by auction. However, the number of new municipal issues has declined significantly since the passage of the 1986 Tax Act.
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:
All municipal bond issues will have an official statement, which contains basic information that an investor would need to know:
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:
Municipal bonds can be classified according to maturities:
| Security | Term | Maturity |
|---|---|---|
| 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 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.
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:
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 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.
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.
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.
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.
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