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A municipal bond (muni) is sold by a state, county or city to obtain funding for a project, perhaps a new stadium.
Like any bond, purchasing a muni amounts to lending money to the seller.
In return, the seller (also called the issuer) promises to repay you with interest in the future.
Many munis are sold in 5k USD increments and pay interest semiannually (twice per year).
These bonds vary from short-term to over 30 years to maturity.
Interest rates are typically less than corporate bonds because munis are safer and have tax advantages.
Buying munis
The are three ways to buy munis:
- new issue,
- secondary market, and
- bond funds.
A new issue is a bond that has not already been held by others—you are the first holder.
Some munis are re-sold before they mature, creating a secondary market.
Finally, you can purchase munis in a bond fund.
These funds often provide diversification by including bonds from dozens or hundreds of different issuers.
You will need to pay a fee for the convenience of such a bond fund.
Regardless of the option chosen, you’ll buy and sell munis through a broker.
It's important to understand all fees including any "markup"—a sales price above the face value of the bond.
Muni brokers are required to disclose pricing information so that you can understand these fees.
They must register with the
Municipal Securities Rulemaking Board (MSRB).
General obligation Vs Revenue Munis
There are two types of munis to be aware of: general obligation (GO) and revenue.
Revenue bonds are used to pay for things like sports stadiums or toll roads.
Revenue generated from the project will be used to pay you.
If the project fails to earn the expected money, you may lose some or all of your investment.
General obligation (GO) bonds pay for things like parks, sewers or schools that don’t earn revenue.
These are backed by the “full faith and credit” of the seller, and are not tied to a specific revenue stream.
These are generally lower risk than revenue bonds because they will pay out as long as the issuer can find a way to do so, including raising taxes.
In rare cases, the issuer may not have tax authority and otherwise be unable to avoid default.
There are no assets that you can claim if the issuer is unable to pay you.
Insurance
Some munis are insured by a 3rd party who promises to provide payments if the issuer defaults.
While unlikely, it’s possible the insurer could also default.
For this reason, it’s recommended to consider the credit rating of both the insurer and the issuer of these bonds.
Taxes
A key advantage of municipal bonds is tax exemption.
Most munis are exempt from federal taxes.
If the investor lives in the state of the issuer, local/state taxes may be excused as well.
This is most advantageous for investors in high tax brackets.
Realize some munis may not be exempt from federal taxes.
If proceeds are used for trading, private business stimulation or other activity that’s not of sufficient “public benefit,” interest payments may be taxed.
The broker should be able to tell you this before purchasing a bond.
Munis bought below face value, in the secondary market, will be taxed upon redemption.
This could be a capital gains tax or even ordinary income according to the
de minimis rule.
This is not an exhaustive account of the tax rules.
Please see a tax advisor for more information.
Risks
While munis are generally safer than corporate bonds or stocks, they do have risks.
Some of these risks are described below.
Default risk.
Munis have a low default risk: they are about 100x less likely to default than corporate bonds.
However, there is still some risk.
For example, Detroit defaulted on munis in 2013 and Puerto Rico did the same in 2016.
As stated earlier, the default rate of revenue munis is higher than general obligation munis.
Call risk.
Many municipal bonds are “callable,” meaning the issuer has the right to “end the deal” at any time by paying you the face value on the bond.
For example, if interest rates decline, the issuer may call the bond back to save money (they can then issue a new bond at a lower rate).
You must forfeit the interest payments you were expecting.
Interest rate risk.
While the interest rate associated with a muni is fixed, the value it will sell for in the secondary market fluctuates inverse to interest rates.
This is logical if you think about it.
If interest rates increase, why would someone buy your bond with an older/lower rate when they could buy a new one with a higher rate?
The only way you can entice them to buy it is to sell it below face value, so that the effective interest rate—relative to the lower price they paid—is higher.
Conversely, if interest rates decrease, your bond pays a higher/older rate that buyers will pay more for.
Interest rate risk is smaller for short-term bonds.
There’s less time for rates to change and there are fewer interest payments affected.
For longer term bonds this risk is substantial.
Inflation risk.
Municipal bonds are fixed rate—interest payments remain the same throughout the life of the bond, independent of inflation.
If your municipal bond pays 5% and inflation is 2% you receive a 3% real return.
This means you gain 3% purchasing power per year by holding the bond.
If inflation rises to 6% your real return drops to -1% and you loose purchasing power by holding the bond.
Legislative risk.
As discussed above, a key advantage of munis is tax exemption.
Unfortunately, tax laws may change.
There’s a risk that you end up paying unexpected taxes on interest or sales that eat away your reason for making the investment.
Liquidity risk.
Even if you plan to hold a bond to maturity, life happens.
You may lose your job, get sick or suffer any number of emergencies.
You may need to sell your munis before maturity.
There’s some risk that, in this scenario, there’s little or no market for the particular bond you hold.
In this case, you may struggle to find a buyer and be forced to sell it at a substantial loss.
Ratings
Munis are rated by 3 agencies:
S&P global,
Moody’s, and
Fitch.
While Moody's and S&P focus on the issuer's financial condition and credit history, ratings take into account things like:
- the economy,
- debt structure,
- the issuer’s financial condition,
- demographic factors, and
- history of the governerning body.
On the Moody’s rating scale, issues rated Baa3 or above are generally considered to be investment-grade (others have a significantly higher degree of risk).
On the S&P rating scale, issues rated BBB– or above are generally considered to be investment-grade.
Special types of munis
Zero-coupon bonds.
Zero-coupon municipal bonds do not pay interest.
Instead, a certain value is paid at maturity (which effectively is the principal plus all interest).
Prices of these bonds are typically very volatile in the secondary market.
Original-issue discount bonds.
These munis are issued at a price below face value.
If held to maturity, the difference between the issue price and the face value is treated as tax-exempt income rather than as capital gains.
Market discount bonds.
As discussed above, munis sometimes trade on the secondary market at a discount to the original issue price (e.g. if interest rates rise or the issuers credit rating falls).
These bonds are referred to as market discount bonds, particularly when the amount of the discount exceeds a certain calculated amount specified under the Internal Revenue Code.
Pre-refunded bonds.
Pre-refunded bonds result from the refunding bonds that are not yet redeemable.
The proceeds are placed in an escrow account from which interest and principal are paid up to a specified call date.
The goal is typically to provide present-value savings to the issuer, or in some cases change the indenture on the bonds.
The escrow account is typically funded with U.S. Treasuries or other safe assets.
Housing bonds.
Housing bonds are revenue bonds used to pay for affordable housing development.
These bonds can be called at any time from and are subject to extraordinary redemption (ER) provisions.
Municipal notes.
Municipal notes are short-term munis that mature in 3 months to 3 years from issue.
They are often used to fund construction projects.
They often don’t pay periodic interest but instead repay principal and all interest at maturity.
Municipal notes have various sources cash flow, such as Tax Anticipation Notes (TANs), Revenue Anticipation Notes (RANs), and Bond Anticipation Notes (BANs).
Conduit bonds.
Conduit bonds are issued by municipalities (conduit issuers), but they merely act on behalf of the actual borrowers (conduit borrowers), which are typically private, nonprofit entities.
Conduit bonds may be issued for nonprofit hospitals, housing developments, or colleges.
Although the conduit issuer makes interest payments and principal repayments, they are typically not obligated to use other sources to repay these bonds.
If conduit borrower fails to make loan repayments, you could be in trouble.
In other words, unless the official statements indicate otherwise, the issuing governmental agency is not a guarantor of these bonds.
Build America Bonds (BABs).
These bonds were created in 2009 with interest payments subsidized by the Federal government.
They helped finance municipalities and stimulate the economy after the 2008 financial crises.
Thes bonds are no longer available.
Further information
The Municipal Securities Rulemaking Board (MSRB) protects
Investors and municipalities by promoting a fair and efficient municipal securities market.
The MSRB’s
Electronic Municipal Market Access (EMMA®) website provides public access to municipal securities documents and data.
From this site you’ll also find links to webpages aimed at investors for specific municipal bonds.
You can further information about municipal bonds from brokerages like
Vanguard.
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