Municipal Bond Overview and Investment Guide

Municipal bonds are a type of investment that allows individuals to lend money to local governments and other public entities, earning interest in return.

They're often considered a safe and stable investment option, as the interest payments are tax-exempt, making them an attractive choice for those in higher tax brackets.

The interest rates on municipal bonds are typically lower than those on corporate bonds, but the tax benefits can make up for the difference.

Municipal bonds can be issued for a variety of purposes, such as financing infrastructure projects, refinancing existing debt, or funding public services.

A bond is a fixed income or debt instrument that allows an investor to provide money to a borrower through a contractual arrangement. Bonds are typically issued by government entities or corporations to finance their projects and operations.

The specifications of a bond include details such as maturity date, face value, issuing price, and stated interest rate, also known as the coupon rate.

Here are some key bond characteristics that can influence their prices and performance:

Government entities, such as municipal governments, are typically of very little credit risk, especially the federal government, since they can theoretically print off any money they need to service any debts.

Investing in municipal bonds can be a stable and low-risk option for investors. Most municipal bonds are issued in $5,000 increments, but some exchange-traded funds (ETFs) and mutual funds allow investors to purchase bond fractions.

The benefits of municipal bonds include stability of capital with low default rates and tax-exempt interest. Interest from munis is generally exempt from federal taxes, making it an attractive investment. Lower interest rates compared to riskier investments like corporate bonds or stocks are also a consideration.

Municipal bonds can be a good option for tax-free income for qualified residents, but they typically pay lower coupon (interest) rates compared to taxable bonds.

Here are some key things to consider when investing in municipal bonds:

Investing in municipal bonds can offer a range of benefits, including tax exemptions.

The interest you earn from tax-exempt municipal securities is generally exempt from federal income tax and in some cases, state or local income tax, depending on your residency.

Tax-exempt income can result in yields being comparable or even higher than taxable bonds, despite lower coupon rates.

Original-issue discount bonds may receive special tax treatment if held until maturity, with the difference between issue price and face value considered tax-exempt income rather than capital gains.

Here are some key tax benefits of municipal bonds:

Coupon rates on municipal bonds are generally lower than those of comparable corporate bonds, but higher than those of FDIC-insured counterparts like CDs, savings accounts, and money market accounts.

When investing in municipal bonds, it's essential to consider the term lengths available. Municipal bonds are available in a variety of terms ranging from two to 30 years.

You can choose a term length that aligns with your investment goals and risk tolerance.

Municipal bonds are generally considered safe investments, but they do come with some risks and considerations.

Default risk is low for municipal bonds, but revenue bonds are more vulnerable to changes in consumer tastes or economic downturns.

A bond's market price fluctuates with changes in interest rates, which means that when interest rates rise, bond prices decline.

Municipal bonds with longer maturities are more susceptible to interest rate changes, causing greater changes in an investor's income.

The majority of municipal bonds are illiquid, making it difficult for investors to sell them quickly if needed.

Many municipal bonds carry call provisions, allowing the issuer to redeem the bond prior to the maturity date, which can result in investors losing income from interest payments.

Historical default rates have been lower in the municipal sector than in the corporate market, but sharp drops in property valuations can strain state and local finances, potentially creating municipal defaults.

Default risk can be greatly reduced through municipal bond insurance, which promises to pay interest and principal if the issuer does not do so.

Municipal bonds are not backed by the federal government and can default from time to time, but they are still a safer alternative to corporate bonds.

Issuers will often use a call provision when market interest rates are low, allowing them to pay off a bond with a higher interest rate and reissue a new bond with a lower interest rate.

Municipal bonds can be categorized based on the source of their interest payments and principal repayments. There are different types of municipal bonds, each with its own benefits, risks, and tax treatments.

A general obligation bond is issued by governmental entities and not backed by revenue from a specific project. Some general obligation bonds are backed by dedicated property taxes, while others are payable from general funds.

Revenue bonds, on the other hand, secure principal and interest payments through the issuer or via sales, fuel, hotel occupancy, or other taxes. When a municipality is a conduit issuer of bonds, a third party covers interest and principal payments.

General obligation bonds are backed by an issuer's full faith and credit, including its power to tax. This means that these bonds typically require voter approval and are subject to limits on total debt outstanding.

Revenue bonds and bonds secured by anticipated legislative appropriations are not subject to these requirements or limits. In 2018, roughly 58 percent of state and local issuances were revenue bonds.

Here are the main types of municipal bonds:

The federal tax exemption for municipal bonds has been in place since 1913, exempting interest payments from taxable income. This exemption has been upheld by the US Supreme Court in several cases, including Department of Revenue of Ky. v. Davis in 2008.

In 1895, the Supreme Court held in Pollock v. Farmers' Loan & Trust Co. that the federal government had no power to tax interest on municipal bonds, but this decision was effectively overruled by subsequent case law. The Revenue Act of 1913 first codified the exemption of interest on municipal bonds from federal income tax.

The tax exemption has been estimated to have cost $27 billion in forgone tax revenues in 2022, according to the Joint Committee on Taxation. This subsidy functions as a federal subsidy to state and local public infrastructure investment.

The federal government's power to tax interest on municipal bonds has been a topic of debate for over a century. The U.S. Supreme Court held in Pollock v. Farmers' Loan & Trust Co. (1895) that the federal government had no power under the U.S. Constitution to tax interest on municipal bonds.

However, in the case of South Carolina v. Baker (1988), the Supreme Court ruled that Congress could tax interest income on municipal bonds if it so desired. This decision effectively overruled the contrary decision of the Court in Pollock.

The Revenue Act of 1913 first codified exemption of interest on municipal bonds from federal income tax. This exemption allowed state and local governments to borrow more cheaply than other debt issuers.

The Tax Reform Act of 1986 greatly reduced private activities that may be financed with tax-exempt bond proceeds. This change aimed to limit the use of tax-exempt bonds for non-public purposes.

Most state and local bonds are held by households, followed by mutual funds, which also represent household investors. This is likely due to the tax benefits of holding municipal bonds, which were reduced after the Tax Reform Act of 1986.

Banks and life insurance companies used to be more prominent municipal bond holders, but they've since taken a backseat in the market. This shift is a result of the Tax Reform Act of 1986 and subsequent litigation that limited the tax benefits of holding municipal bonds.

Households and mutual funds now hold the majority of state and local government debt, making up a significant portion of the municipal bond market.