Strategy
Insights
Taxable Municipal Bonds
Fourth Quarter 2013
Increased financial flexibility for issuers and a growing demand from investors seeking attractive
relative value are driving the recent increase in issuance of taxable municipal bonds (munis) — a
growing subset of the $3.7 trillion municipal bond market1. While sectors, credit quality and risks are
similar to those of tax-exempt bonds, the taxable feature often makes these munis more appropriate
for certain types of investors.
New trend: Raising funds with taxable munis
Craig Falduto
Director of Unit Trust
Investment Research
Invesco Unit Trusts
Retail investors have historically been a significant player in the municipal bond market, which
consists primarily of general obligation and revenue-backed bonds issued by states, local
governments and government-related entities. Because interest on these bonds is generally not
taxed at the federal level, borrowing costs are kept low for local governments, and individual
investors enjoy an attractive after-tax yield.
A new trend in the municipal space is a growing number of issuers who are choosing to raise funds
via the taxable municipal market. As the charts below illustrate, the issuance of taxable munis as a
percentage of total muni issuance has generally trended upward since 2004. Notably, taxable muni
issuance is up 27% year-over-year in dollar terms as of Sept. 30, 2013 (see chart below). While the
spike in taxable issuance in 2009 and 2010 was related to the Build America Bonds (BABs) program,
the rising trend in 2013 is being driven by strategic taxable issuance and refundings. The success
of the BABs program greatly expanded the base of buyers which may set the stage for a growing
taxable market.
Shaun Peters, CFA
Senior Investment
Research Analyst
Invesco Unit Trusts
Taxable Muni Issuance Has Trended Upward Since 2004
• % of total muni issuance
%
40
2004
2005
2006
35
30
25
20
15
10
5
0
Source: Thomson Reuters 9/30/13
1 SIFMA 8/31/13
2007
2008
2009
2010
2011
2012
2013
Taxable Muni Issuance Spikes Since 2012
Taxable Muni Issurance is up +27% YTD
$ billions
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
2012 YTD issuance
2013 YTD issuance
Source: Thomson Reuters 9/30/13
Many issuers have found that paying a slight interest premium to issue taxable bonds is more than
offset by the additional flexibility. Issuing tax-exempt bonds involves substantial monitoring and
recordkeeping costs to ensure preservation of the tax-exempt status. Whereas, issuing taxable bonds
eliminates this ongoing cost. There are also restrictions on the use of proceeds of tax-exempt bonds.
Issuers in the Higher Education sector are finding that taxable issuance allows greater flexibility for
research activities that often involve corporate partnerships. In addition, some issuers in the Health
care and Transportation sector have been opportunistically raising capital in the debt markets to
increase cash reserves for future deployment — an initiative that must generally be done in the
taxable market. Refundings are up this year as many issuers have taken advantage of low rates to
refinance higher coupon debt.
Largest Taxable Deals Issued YTD
Issuer
Credit Rating
S&P
Credit Rating
Moody’s
Issue Size
($ million)
1. Florida Hurricane Catastrophe Fund
AA-
Aa3
2,000
2. JobsOhio Beverage System
AA
A2
1,106
3. Missouri Higher Education Loan Authority
AA+
—
956
4. University of California
AA
Aa1
788
5. Kentucky Higher Education Student Loan Corp.
AA+
—
564
6. North Carolina State Education Asst. Authority
AA+
—
541
7. Denver School District No. 1
AA-
Aa2
537
8. Vermont Student Assistance Corp.
AA+
—
371
9. State of California
10. State of Illinois
A
A1
364
A-
A3
350
Source: Thomson Reuters, data through July 13, 2013
Taxable muni bond programs
In addition to strategic taxable issuance and refundings, there are also several types of federal
programs that support taxable issuance by municipalities. These programs lower borrowing costs for
local governments and promote a specific policy objective, such as energy conservation or school
infrastructure. Under these programs, local governments issue bonds in the taxable market at a
higher gross interest rate than the prevailing tax-exempt rate. The local government then receives a
direct payment for a portion of its interest cost from the federal government, lowering net borrowing
costs while meeting policy objectives. Two taxable muni bond programs include:
•Build America Bonds (BABs). BABs were created by the American Recovery and Reinvestment
Act of 2009 to encourage local governments to finance projects that would create jobs and
stimulate the economy. The BABs program proved very successful, with more than $180 billion
of issuance in 2009 and 2010. BABs attracted new investors to the municipal bond market and
still account for a significant part of the taxable muni market, although the program closed to new
issuances at the end of 2010.
2 •Qualified tax credit bonds. Similar to BABs, these programs were created by tax legislation and are
designed to encourage local governments to invest in key areas. A few of these programs include
Qualified Zone Academy Bonds (QZABs), Qualified School Construction Bonds (QSCBs), Qualified
Energy Conservation Bond (QECBs) and Qualified Clean Renewable Energy Bonds (CREBs).
Taxable muni basics
Like their tax-exempt counterparts, taxable muni bonds are generally issued by states, local
governments and government-related entities, such as school districts, public and private
universities, community colleges, public utilities and not-for-profit health care systems. Unlike taxexempt munis — which are exempt from federal taxes and sometimes state taxes — taxable muni
bonds are fully taxable at the federal level for several possible reasons, including:
•The bonds were issued through a qualified tax credit program, in which the local borrower issues
taxable bonds and then receives reimbursement from the federal government.
•The bonds do not meet the Internal Revenue Service requirement that tax-exempt issues have a
direct public benefit. While there is subjectivity in interpretation, certain deal structures generally
do not meet the criteria for tax-exempt status. These include bonds issued to build sports
stadiums, fund industrial development, improve public pension funding levels or simply add cash
reserves to the balance sheet for greater financial flexibility.
•Bonds that have been refunded multiple times by borrowers generally do not receive tax-exempt status.
Like all types of fixed income investments, taxable muni pricing and value are driven by:
•Issuer-specific credit quality and security features.
•Market interest rates and spreads.
•Relative value compared with other fixed income markets.
•Supply and demand dynamics.
The chart below illustrates the sector breakdown of the currently $490 billion of outstanding taxable
munis:
Taxable Muni Sectors
$ billions outstanding
$120
100
80
60
40
20
0
General
Obligation
School
District
Water
& Sewer
Higher
Education
Student
Loan Revenue
Pension
Obligations
Public
Power Systems
Source: Bloomberg 9/30/13
Why consider investing in taxable munis?
Taxable munis offer several potential advantages, including:
•Access to high-quality municipal sectors in a taxable format.
•Greater suitability for tax-deferred accounts
•Potential for attractive yields relative to other taxable fixed income sectors.
Strategy Insights: Taxable Municipal Bonds 3
Taxable munis appeal to a wide range of investors who want access to the high-quality municipal
market but may be unable to fully benefit from the tax-exempt feature of traditional muni bonds.
Specifically, taxable munis may be attractive for:
•Holders of tax-deferred accounts such as IRAs and 401(k).
•Investors in lower income tax brackets.
•Investors who cross over from other taxable fixed income sectors when valuations are attractive.
•International investors.
Invesco’s outlook on the taxable muni market
Invesco views the trend of increasing issuance of taxable munis as favorable for both issuers and
investors. The success of the BABs program expanded the base of buyers which set the stage for a
growing taxable market. This, in turn, has increased depth and liquidity in the market, which benefits
investors. Issuers also benefit from additional options taxable munis afford them for raising capital.
Invesco has an expertise in credit selection and portfolio construction, and is well positioned to take
advantage of the opportunities in the growing taxable muni market.
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The opinions expressed are those of the author as of October 1, 2013, and are subject to change without notice. These opinions may differ from those of other
Invesco investment professionals.
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