Municipal Bonds (Part 1)

For today’s article/post, I’ll be starting part one of a lengthy municipal bonds coverage series.  Hence, part one’s objective is to provide an introduction to municipal bonds, different types and their general advantages.  For sources, I will be using Bonds by Hildy Richelson and Stan Richelson, Primer on Municipal Bonds by Invesco and Real Returns of CDs vs. municipal bonds by Putnam Investments.  

Municipal bonds or muni-bonds are often thought of as tax-exempt vehicles for investors in the 24% tax bracket and above ($82,501+ Single Income or $165,001+ Joint Income).  Beyond the tax exemptions, 5 attributes also attract investors to municipal bonds.

  • Low refinancing risk. Municipal debt is typically self-amortizing where periodic debt service payments consist of both principal and interest.  This structure enables repayment of principal with less reliance on future market access.
  • High credit quality. These tend to be highly rated
  • Low default rate. Compared to other fixed income asset classes, municipal bonds have had low historical default rates
  • Diversification. These issues have had a low historical correlation with other major asset classes
  • Attractive yields. Municipal bond yields compare favorably to major fixed income segment, even exclusive of their tax advantage.

As for a brief history of muni-bonds, they were first issued the early 1800’s and often are credited with helping build the canals, highways, roads and railroads that fueled the United States westward expansion.  Today, municipal bonds are issued by US state and local governments (municipalities) and eligible not-for-profit corporations. Municipal bonds can also be issued by territories and possessions of the US (i.e. Puerto Rico, Guam, the US Virgin Islands and American Samoa).  When an investor purchases a municipal bond, he or she is lending to build schools, highways, hospitals, sewer systems and a myriad of other public projects. The appeal is that municipal bond interest payments typically are exempt from federal income taxes and state income taxes for in-state residents.  For taxpayers, to determine the desirability of a given municipal issue, it is necessary to calculate the tax-equivalent yield and then compare it with its taxable counterpart in the US Treasury, agency, corporate or sovereign bond market (more on this in part two).

Municipal bonds are also split into general obligation bonds and revenue bonds.  

  1. General obligation bonds are backed by a state government pledge to use all available resources to repay the bond.  For local government issued general obligation bonds, they are backed by ad valorem tax pledge that is referred to as either “limited” or “unlimited.”  
  • Limited tax: Secured by a pledge to levy taxes annually “within the constitutional and statutory limitation provided by law.”
  • Unlimited tax: Secured by a pledge to levy taxes annually “without limitation as to rate or amount” to ensure sufficient revenues for debt service.

    Examples of general obligation bonds include states, cities and school districts.

  1. Revenue bonds are backed by a specific source of income and are split into “enterprise” revenue bonds and “tax” revenue bonds.
  • Enterprise bonds: Are typically issued by not-for-profit entities such as airports, toll roads, hospital, electric utilities, sewer authorities and universities
  • Tax bonds: Are backed by dedicated tax streams, such as a sales tax, utility tax or excise tax.

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