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, and municipal authorities. Municipal bonds are usually issued to finance specific projects. The bonds are repaid either with tax revenue or from revenue generated by the financed project. Munis (aka municipals), as municipal bonds are often called, are issued for immediate funds and to finance specific projects. Municipals are sold by auction. There are many different types of municipal bonds, classified according to the type of project being financed, maturity, and the source of the tax revenue used to make bond payments.

Overview of the Taxation of Municipal Bonds

The primary advantage of most municipal bonds for the investor is that the interest is exempt from federal taxes, and are also usually exempt from state and local taxes, if the bond was issued by a municipality within the taxpayer's state and municipality — triple exempt. These tax exemptions, where US Treasuries are exempt from state and local taxes and municipal bonds are exempt from federal taxes, were created under the Doctrine of Reciprocal Immunity (Doctrine of Mutual Reciprocity), established in 1895 by a US Supreme Court decision. Munis issued by United States territories and possessions are also triple exempt.

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 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 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.

A de minimis tax applies to munis acquired at a market discount. If the discount exceeds 0.25% of the face value for each full year from the time of purchase to maturity, gains from the discount are taxed as ordinary income, even for a municipal bond that is not subject to federal taxation. However, if the discount is less than the de minimis threshold, then the discount is treated as a capital gain.

If bond price < bond price − de minimis threshold value, then the discount is taxable as a capital gain.

So, if the purchase price of the bond in this example is less than $100 $2.50 = $97.50, then the gain due to the discount is taxable as a capital gain.

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.

The federal tax-exempt interest from municipal bonds increases the modified adjusted gross income used to determine Medicare premiums, which may increase premiums for Medicare Part B or Medicare prescription drug coverage for wealthy Medicare recipients.

Tax-free interest may also increase the income used to determine other exemptions or tax credits, leading to more taxes overall:

There are 2 types of municipal bonds, however, whose interest is subject to federal taxation. One type is the Build America Bonds, which were issued in 2009 and 2010 to stimulate the economy out of the Great Recession 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 by the federal government. Another type of bond that may be subject to federal taxes 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 = 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

For major municipal bond issues, the 1st step is to obtain a legal opinion, which will determine whether and how the issue will be offered. Smaller bond issues may not have a legal opinion, in which case, the bond certificate must clearly state that the bonds are without a legal opinion, with the designation ex-legal.

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 restrictions of the issuer's taxing authority, ensures that the physical bond certificate is proper, and that the debt is legally binding on the issuer. The terms of the bond offering are set either by negotiation or competitive bidding.

The legal opinion can either be unqualified or qualified. An unqualified opinion is given unconditionally, but a qualified opinion indicates that there is some legal uncertainty, which the purchasers should be aware of.

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.

Indenture

The bond certificate may refer to a trust indenture or bond resolution, which authorizes the issuance and sale of municipal bonds, and includes a description of the bonds. A trustee must be hired to supervise the issuer's compliance with the bond covenants. 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, since bonds with indentures are more marketable than those without, and, thus, can be sold with lower yields. Generally, the indenture contains the following provisions:

Indentures will also include an additional bonds test, which must be satisfied before more bonds can be issued based on the same revenue stream.

The indenture is not usually given to bondholders, but the issuer must send a complete copy upon request.

Official Statement

All municipal bond issues will have an official statement (OS), which contains basic information that an investor would need to know. The OS, equivalent to a mutual fund prospectus, must be signed by an officer of the issuer. The OS usually contains the following:

A municipal securities dealer selling the new issue must send the official statement to every investor at or before the settlement date.

A preliminary official statement is usually prepared before the official statement as a way to determine dealer and investor interest in the issue. It has everything that is in the official statement except the issue's interest rates or offering price, since these have yet to be determined.

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 exceeding $50,000.

New Developments

Deficient Disclosures by Municipal Bond Issuers

https://www.nytimes.com/2008/08/31/business/31gret.html

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:

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:

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

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