Municipal bond
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In the United States, a municipal bond (or muni) is a bond issued by a state, city or other local government, or their agencies. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, school districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state level. Municipal bonds are guaranteed by a local government, a subdivision thereof, or a group of local governments, and are assessed for risk and rated accordingly. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
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[edit] Purpose of municipal bonds
[edit] Municipal bond issuers
Municipal bonds are issued by states, cities, and counties, or their agencies (the municipal issuer) to raise funds. The methods and practices of issuing debt are governed by an extensive system of laws and regulations, which vary by state. Bonds bear interest at either a fixed or variable rate of interest.
The issuer of a municipal bond receives a cash payment at the time of issuance in exchange for a promise to repay the investors who provide the cash payment (the bond holder) over time. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer.
The issuer typically uses proceeds from a bond sale to pay for projects or for other purposes it cannot or does not desire to pay for immediately with funds on hand. Tax regulations [1] governing municipal bonds generally require all money raised by a bond sale to be spent on one-time capital projects within three to five years of issuance. Certain exceptions permit the issuance of bonds to fund other items, including ongoing operations and maintenance expenses, the purchase of single-family and multi-family mortgages, and the funding of student loans, among many other things.
Because of the special tax-exempt status of most municipal bonds, investors usually accept lower interest payments than on other types of borrowing (assuming comparable risk). This makes the issuance of bonds an attractive source of financing to many municipal entities, as the borrowing rate available in the open market is frequently lower than what is available through other borrowing channels.
Municipal bonds are one of several ways states, cities and counties can issue debt. Other mechanisms include certificates of participation and lease-buyback agreements. While these methods of borrowing differ in legal structure, they are similar to the municipal bonds described in this article.
[edit] Municipal bond holders
Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an upfront investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself (see bond).
Repayment schedules differ with the type of bond issued. The issuer may make equal amortized interest and principal payments every six months, may make only interest payments until the bond matures and then repay the entire principal amount, make one lump-sum payment at maturity, or some mix of these options.
The interest income on a municipal bond may be tax-exempt. This makes municipal bonds an attractive investment to certain investors, and results in investors accepting a lower interest rate on their investment than they would on a taxable investment of equivalent risk.
[edit] Characteristics of municipal bonds
[edit] Taxability
One of the primary reasons municipal bonds are considered separately from other types of bonds is their special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt from all federal taxes, as well as state or local taxes depending on the state in which the issuer is located, subject to certain restrictions. Bonds issued for certain purposes are subject to the alternative minimum tax.
The type of project or projects that are funded by a bond affects the taxability of income received on the bonds held by bond holders. Interest earnings on bonds that fund projects that are constructed for the public good are generally exempt from federal income tax, while interest earnings on bonds issued to fund projects partly or wholly benefiting only private parties may be subject to federal income tax.
The laws governing the taxability of municipal bond income are complex; however, bonds are typically certified by a law firm as either tax-exempt (federal and/or state income tax) or taxable before they are offered to the market. Purchasers of municipal bonds should be aware that not all municipal bonds are tax-exempt.
[edit] Risk
Main article: credit risk
The risk ("security") of a municipal bond is a measure of how likely the issuer is to make all payments, on time and in full, as promised in the agreement between the issuer and bond holder (the "bond documents"). Different types of bonds carry different securities, based on the promises made in the bond documents:
- General obligation bonds promise to repay based on the full faith and credit of the issuer; these bonds are typically considered the most secure type of municipal bond, and therefore carry the lowest interest rate.
- Revenue bonds promise repayment from a specified stream of future income, such as income generated by a water utility from payments by customers.
- Assessment bonds promise repayment based on property tax assessments of properties located within the issuer's boundaries.
In addition, there are several other types of municipal bonds with different promises of security.
The probability of repayment as promised is often determined by an independent reviewer, or "rating agency". The three main rating agencies for municipal bonds in the United States are Standard & Poor's, Moody's, and Fitch. These agencies can be hired by the issuer to assign a bond rating, which is valuable information to potential bond holders that helps sell bonds on the primary market.
[edit] Comparison to corporate bonds
Because municipal bonds are most often tax-exempt, comparing the coupon rates of municipal bonds to corporate or other taxable bonds can be misleading. Taxes reduce the net income on taxable bonds, meaning that a tax-exempt municipal bond has a higher after-tax yield than a corporate bond with the same coupon rate.
This relationship can be demonstrated mathematically, as follows:
rm = rc ( 1 - t )
where
rm = interest rate of municipal bond rc = interest rate of comparable corporate bond t = tax rate
For example if:
rc = 10% t = 38%
then
rm = .10 (1 - .38) = 6.2%
A municipal bond that pays 6.2% therefore generates equal interest income after taxes as a corporate bond that pays 10% (assuming all else is equal).
Because longer maturity municipal bonds tend to offer significantly higher after-tax yields than corporate bonds with the same credit rating and maturity, investors in higher tax brackets may be motivated to arbitrage municipal bonds against corporate bonds using a strategy called municipal bond arbitrage.
[edit] External links
- The Bond Buyer, newspaper focusing on the municipal bond industry.
- The Bond Market Association, the industry trade group.
