Municipal Bonds
Municipal bonds are debt instruments issued by states, counties,
cities and local government authorities such as a school or water
district. The proceeds of municipal bond issues are used for a wide
range of public purposes, including building schools, highways or
airports, or to fund general government operations.
Perhaps the most notable feature of municipal bonds is the tax
treatment of the interest income received. With a few limited
exceptions, interest income from municipal bonds is exempt from
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federal income tax. See IRC Sec. 103(a). Generally, municipal bond interest is also exempt from state
and local income tax if the bondholder resides in the same jurisdiction where the bond was issued.
Municipal bonds typically pay interest on a semi-annual basis. On the open market, they normally trade
in multiples of $5,000 (par value).
Types of Municipal Bonds
There are two primary categories of municipal bonds.
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General obligation: Also known as G.O. bonds, these bonds are secured by the full faith and credit
of the issuer. In effect, this means the full taxing power of the issuing government or agency.
Revenue bonds: Revenue bonds are bonds issued by agencies such as a port authority, highway
commission or water and sewer district, to build specific public works projects. Such bonds are
backed by the revenues generated by these projects for payment of principal and interest.
Other Municipal Bond Concepts
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Private activity bonds: Private Activity bonds are municipal bonds which serve mixed public and
private purposes. Unless such bonds meet certain requirements (IRC Sec. 103(b)), the interest
income from them is not exempt from federal income tax. State and local taxability will vary. Interest
income on private activity bonds which do meet the requirements is federally tax-exempt; in certain
cases, interest income from tax-exempt private activity bonds is a preference item for the alternative
minimum tax (AMT). See IRC Sec. 57(a)(5).
Serial and term bonds: These terms refer to the manner in which a municipal bond issue is
redeemed at maturity. A serial bond issue matures over a number of years, with a portion of the
issue retired each year. With term bonds, the entire bond issue is retired at one time.
Insured municipal bonds: Municipal bonds described as being “insured” carry an additional
protection against the risk of default. A private corporation agrees to pay principal and interest if the
issuer of the bond defaults. Investors should check the credit rating of both the bond issuer and the
corporation insuring the bond. Such insurance protects only against the risk of default, not the market
value of a bond.
To qualify for the federal income tax exemption, bonds issued after 1982 generally must be in registered form. See IRC Sec.
149(a)(1).
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Municipal Bonds
Bond Prices and Interest Rates
If an investor buys a municipal bond and holds it to maturity, the issuer is obligated to repay the full face
amount. If the bond is sold before it matures, however, the investor may receive more or less than
originally paid. Bond prices can move up and down, most often in response to changes in the general
level of interest rates. If rates rise, the price of existing bonds usually falls; if interest rates decline, the
market value of existing bonds generally increases. Municipal bond prices may also be affected by
general business and economic factors.
Income Tax Treatment
The income from municipal bonds is generally exempt from federal income tax and state and local
income tax (if the bondholder resides in the same jurisdiction where the bond was issued.) In some
cases, income from municipal bonds may be subject to the alternative minimum tax (AMT) as well as
capital gains taxes. No federal deduction is allowed for interest or investment expenses attributable to
tax-exempt interest. See IRC Secs. 265(a)(1) and (2). Tax-exempt income is added back to a taxpayer’s
income to determine taxable Social Security. See IRC Sec. 86(b)(2)(B).
Investment Uses
Municipal bonds are attractive to high-tax-bracket individuals seeking a stable source of tax-advantaged
income. They can supplement IRAs and other qualified retirement plans when a taxpayer has already
made the maximum allowable plan contribution.
How to Invest
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Direct ownership: Working with a stockbroker or other securities-licensed professional, investors
can buy bonds directly, holding the bonds in their own names.
Indirect ownership: Open-end investment companies known as mutual funds are an indirect method
of municipal bond ownership. Mutual funds pool the resources of many individuals and offer access
to a diversified, professionally-managed portfolio. Exchange-traded funds, or ETFs, a variation of the
standard mutual fund, are another way of investing in municipal bonds. Unit Investment Trusts (UITs)
are a third form of indirect ownership. The municipal bond portfolio in a UIT is fixed and not actively
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managed.
The Securities and Exchange Commission (SEC) requires that all prospective UIT, ETF, and mutual fund investors be given a
prospectus. The prospectus contains valuable information concerning how an investment works, its goals and risks, and any
expenses and charges involved.
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Possible Risks
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Market risk: If a municipal bond is sold before maturity, an investor may receive more or less than
originally paid.
Default risk: An issuer may default on payment of the principal or interest of a bond.
Inflation risk: As fixed return investments, municipal bonds are subject to inflation risk; over time, the
dollars received have less purchasing power.
Tax risk: Federal or local government law concerning the taxability of municipal bond interest income
could change.
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