Types of Municipal Bonds

There are many types of municipal bonds, and they can be classified in many ways. Municipal bonds can be classified according to maturities:

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 the interest and principal are generally paid from a primary source, double-barreled bonds are also backed by the municipality's general taxing power, so they are rated and treated as general obligation bonds. However, double-barreled bonds are rare nowadays.

Entire issues also can be classified according to maturities. Term bonds , sometimes called dollar bonds, mature in a single year, and, like corporate bonds, are quoted by price; 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.

There may be some overlap of sources for bond revenue. Several tax authorities within a municipality may issue bonds based on real estate taxes on the same property. These bonds are called coterminous debt. States do not tax real estate, so state bonds never overlap.

Municipalities that issued municipal bonds with a call provision and a call protection period may use pre-refunding to lower the interest rate that it is paying, if market interest rates have dropped significantly below the current bond rate. New municipal bonds are issued at the lower market interest rate, and the proceeds are placed in an escrow account, which are invested in special U.S. Treasury securities, known as State and Local Government Security Series (SLGS), which are issued by the U.S. Treasury to municipal bond issuers for the pre-refundings. The investment in these special Treasury securities is necessary to satisfy arbitrage restrictions imposed by the IRS.

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: only that tax can be used to finance payments on the bond. 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.

Revenue Bonds

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. Revenue bonds are supported by special taxes on alcohol, hotels, tobacco, liquor, business licenses, gasoline taxes, and other excise taxes, but not ad valorem taxes. Property taxes generally support general obligation bonds.

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:

1. To pay current interest and principal of the issued bonds.
2. To fund a reserve to provide for up to 2 years of payments of interest and principal.
3. To fund a reserve for the maintenance of the project.
4. 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 depends 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.

AMT Bonds

Prior to the Tax Reform Act of 1986, most 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.

Lease Rental Bonds

Lease rental bonds are often used to finance construction, where the municipality leases the building to another tax authority, such as a school, or may come from the lessor's revenues, or from the general fund of the municipality.

Certificates of participation (COPs) are a type of lease revenue bond permitting the investor to receive some of the revenue from the lease payments related to the acquisition of land or specific equipment, or the construction of facilities by the municipality. COPs do not require voter approval and are not considered debt of the municipality because COPs are repaid as an annual appropriation by the municipality.

National Housing Authority Bonds

National Housing Authority Bonds (NHAs) are issued to construct or improve low-income housing. Sometimes called Public Housing Authority Bonds (PHAs) or Section 8 bonds, bond payments are derived from the rental income, and are backed by the full faith and credit of the US government: if the rental income is insufficient, then the federal government makes up for any deficit. Note, however, that these are not considered double-barreled bonds, because the alternative source of revenue is the federal government, not a state or municipality.

Moral Obligation Bonds

Moral obligation bonds are bonds where the state is perceived to be morally obligated to support the bonds if tax revenues are insufficient to pay the debt. Although the state has legal authority to appropriate funds for bond payments, it is not legally obligated to do so, which is why they are called moral obligation bonds. Moral obligation bonds are revenue bonds only issued during financial distress, when a municipality cannot sell its own bonds or because the municipality has exceeded its statutory limit for debt. Such was the case for New York City during 1975. When a GO bond defaults, bondholders can sue to compel a tax levy to satisfy the creditors.

Variable-Rate Municipal Bonds

Variable-rate municipal bonds, sometimes called variable-rate demand obligations or VR-DOs, are also called reset bonds, because the interest rate is reset to the market interest rate every 6 months.

Auction rate securities (ARSs) are a type of variable-rate municipal bond with long-term maturities of 20 to 30 years, issued by nonprofit hospitals, housing finance agencies, universities, utilities, and other municipalities.

Interest rates are determined by a Dutch auction every so many days, usually 7, 28, or 35 days. This auction uses the competitive bid to establish the lowest bid that would sell all the bonds at par. This lowest bid sets the reset rate, or what is sometimes called the clearing rate. Like competitive bidding for Treasuries, those that bid at least the minimum or higher price will receive there requested bonds at the bid price, while those that bid below receive nothing. The interest rate paid for a given period is determined by the auction in the prior period. Sometimes ARS auctions fail, because of a lack of demand. In such case, there are no bids to reset the rate. This occurred frequently during the Great Recession of 2007 - 2009. Although bond dealers can submit a clearing rate bid, they are not legally obligated to do so. Failed auctions cause credit ratings of the securities to decline. The issuer can call ARSs at par on any interest payment date.

Dealers of variable-rate demand obligations must submit information to the MSRB as part of its Short-Term Obligation Rate Transparency (SHORT) system, providing information on the remarketing and the interest rate set for the next period.

Municipal Notes

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 are usually issued in $25,000 denominations and have maturities that range from 60 days to 1 year. 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. Tax-exempt commercial paper, with common maturities of 30, 60, and 90 days, often replaces BANs and TANs.

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.