(or munis) are
securities issued by state and
local governments in the United States and its territories. They include
securities issued by agencies or authorities established by those
governments. Munis are used to fund items such as infrastructure, schools,
libraries, general municipal expenditures or
refundings of old debt.
When the United States introduced a federal income tax in
1913, the taxability of interest from municipal securities was challenged
based on the constitutional principal of states' rights. That argument was
upheld by the Supreme Court for much of the twentieth century but was
finally rejected in a 1983 case. Today, congress has a right to tax
interest income from municipal securities, but it currently chooses not
to. Many states also exempt their securities from their own taxes, which
makes those securities particularly attractive investments for their own
residents. Of course, capital gains from buying or selling munis in the
secondary market are fully taxed.
Because of their tax-exempt status, munis have
nominal yields below those of
corporate bonds or
Treasury bonds. To
compare a muni's yield to that of a
taxable bond, investors calculate the muni's
tax-equivalent yield using the
This indicates the yield a taxable bond would have to earn
in order to match, after taxes, the yield available on the untaxed muni. Here
marginal tax rate is the tax rate
that would apply to one additional dollar of income—if the investor earned
one additional dollar, what fraction of that dollar would be lost to federal, state
and local income taxes?
Consider an individual investor who pays a marginal tax
rate of 34% due to federal, state and local income tax. To compare a muni
paying 3% with a taxable corporate bond paying 4%, she would apply formula
 to obtain a tax-equivalent yield for the muni of
4.55%. Barring other factors, she would likely invest in the muni, since
its tax-equivalent yield is superior to the 4% yield on the corporate.
Obviously, tax-equivalent yield depends on the investor's
marginal tax rate. If a property and casualty insurance company is losing
money, its marginal tax rate will be 0%. If it compares the same muni
paying 3% and corporate paying 4% as in the previous example, it would
apply formula  to obtain a tax-equivalent yield for
the muni of 3%. Barring other factors, the company would probably invest
in the corporate.
Munis are not always tax exempt. Interest on some munis is
taxed under the Alternative Minimum Tax (AMT). These are called
AMT bonds. If a municipality issues debt to
fund a commercial enterprise, such as a shopping mall or sports stadium,
the securities are called private
activity bonds. To prevent municipalities from engaging in tax
arbitrage—issuing debt at tax-free yields while earning a commercial
rate or return on the
proceeds—interest on private activity bonds is taxable.
To preclude tax arbitrage by securities dealers, any
interest paid to finance a position in munis is not deductible as a
Unlike, the Federal government, which can print money,
municipalities cannot. This means that munis entail
credit risk. There have been a
number of spectacular municipal bankruptcies, so the risk of default is
real. Munis are rated, just like
corporate bonds, with ratings varying from AAA to D. Some munis are issued
with credit enhancement.
This may include credit insurance or a bank guarantee, such as a letter of
Long-term munis are called
municipal bonds. These typically pay semiannual
coupons, but some are
accrued-coupon bonds. These
instruments fall into two general categories:
bonds are backed by anticipated tax, penalty or fee revenue. These
instruments include general
obligation bonds, which are baked by the general tax revenue of
the issuer. Some are are structured like a
securitization of specific
revenues, such as sales taxes or fees. There are also a number of
structures issued by state or local agencies with some sort of credit
enhancement from the state or local government.
bonds are issued to finance specific revenue-producing projects,
such as toll roads, airports, public housing or higher education. Interest
and principal are paid out of revenue from the project. The bonds are
classified by project type, so you will hear of utility revenue bonds,
hospital revenue bonds, transportation revenue bonds, housing revenue
A third category of municipal bond is refunded bonds.
bonds (also called prerefunded bonds) are tax-backed or revenue bonds that the issuer has
allocated funds to fully retire. The issuer hasn't retied the debt yet,
either because it is not yet
callable or for some other reason. Instead, the issuer has used the
allocated funds to buy an offsetting portfolio of
bonds, which are placed in
escrow or a trust for the benefit of bondholders. The portfolio may hold
agency securities or other
high-quality debt. It is structured so its cash flows offset the cash
flows due on the refunded bonds. This may be done in anticipation of the
bonds being called at the first opportunity, or it may be done assuming
that the bonds will be outstanding until maturity. Because they are fully
baked by high-quality collateral,
refunded bonds tend to have excellent
Municipalities issue a number of shorter-term instruments.
Most common are municipal notes.
notes have maturities from three months to three years. Some are
issued as discount
instruments, but most are coupon bearing. Typically, notes are issued
to address mismatches in the timing of expenditures and offsetting
revenues. Tax anticipation notes
(TANs) are issued in anticipation of tax revenues.
Revenue anticipation notes (RANs)
are issued in anticipation of other revenues, such as federal aid.
Tax and revenue anticipation
notes (TRANs) anticipate either tax and/or other revenue.
Grant anticipation notes (GANs)
are issued in anticipation of receiving a grant.
Bond anticipation notes (BANs)
are issued in anticipation of funding from the issuance of municipal
bonds. Most notes are issued with credit enhancement, such as a bank
letter of credit.
In the past, municipalities used
commercial paper to meet
much of their short-term funding needs. This had the advantage that
municipalities didn't have to perform a new public offering each time they
issued short-term debt. Municipal issuance of commercial paper was
severely restricted by the 1986 Tax Reform Act. Since then, municipalities
have turned to various floating rate
instruments, which were first employed in the 1970s. These have long
maturities, so issuers can have infrequent offerings. They also have
liquidity features that make them
essentially money market instruments.
rate demand obligations (VRDOs), also called
variable rate demand notes (VRDNs),
are floating rate instruments with
terms of as much as 40 years. They pay interest monthly or quarterly
based on a floating rate that is reset daily or weekly based on an index
of short-term municipal rates. VRDOs are purchased at
par. Liquidity is provided with a
put feature, which allows the holder
to put the the security for par plus
accrued interest on
any interest rate reset date, usually with one or seven days notice. A
remarketing agent—a bank or other entity—serves as liquidity provider. VRDOs are put back to it rather than the issuer. The remarketing agent
tries to resell those VRDOs or, failing that, holds them in its own inventory. VRDOs almost always have credit enhancement—either a letter of credit from
the remarketing agent or bond insurance. The issuer generally has an
option to convert a VRDO to a fixed rate instrument. Due to the put
feature, tax-exempt money market funds generally can hold VRDOs.
rate securities (ARS) are structured much like VRDOs, but rates
are reset and liquidity is provided through a periodic Dutch auction.
Investors who wish to acquire an ARS submit bids in that auction.
Investors who already hold the ARS have a choice to hold (agree to receive
whatever rate is set in the auction), bid (bid in the auction, and
relinquish their holding if their bid is not accepted), or sell (redeem
their investment at par plus accrued interest, irrespective of auction
results). For tax-exempt ARS, auctions are typically held every 7, 28 or
35 days. Interest is usually paid the day after the auction, but less
frequent coupon dates are possible. Instruments usually have some form of
credit enhancement. Tax-exempt money market funds generally can't hold
While VRDOs and ARSs are unusual, most municipal
securities are issued as traditional
public offerings. There is an active
market for munis. Tax exempt investors, such as pension plans, don't
generally invest in munis. Most munis are held by property and casualty
insurance companies, wealthy individuals who have the highest marginal tax
rate, and mutual funds that invest exclusively in munis. Banks or other
dealers also hold inventories of municipal securities.
The phrase tax-exempt bond
refers to any bond whose interest is not subject to taxation by one or
more authorities. In the United States, the term is often used
synonymously with municipal bonds. However, non-profit entities like
hospitals and museums also issue bonds that are tax exempt. These are
structured much like munis, and they are sold to mostly the same
agency security A
security issued by a US federal agency or government sponsored enterprise.
bond Securitized debt.
Interest that is earned but not yet paid on a bond.
registered and bearer bonds Three forms of bonds differing in
how ownership is evidenced.
callable bond A bond which allows the issuer to repurchase the bond for a specified
price on certain dates prior to the bond's maturity.
A bond issued by a corporation.
credit risk Risk due to
uncertainty in a counterparty's ability to meet its obligations.
A fixed income instrument whose coupon fluctuates with some designated reference
bond Any bond issued or invested in across national boarders.
par value A stated
value for a security.
date the date on which the owners of a security are identified
for the purpose of making an upcoming interest or dividend
financial instrument such as a stock or bond.
A provision that requires an issuer of bonds or preferred stock to retire some of the
issue each year.
US Federal Government debt obligation issued by the Department of Treasury.
United States financial regulation An overview.
Any of several metrics of the income or return to be earned from an investment.
bond A bond that pays no coupons, pays its par value at
maturity and is issued at a discount.
and Fabozzi (2002)
both have detailed discussions of municipal securities.
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