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How to Understand the Municipal Bond Market

Updated on May 22, 2012

Municipal Bonds 101

The bond market is the largest public securities market in the world, and substantially larger than the stock market. When investors allocate assets in their investment portfolios, often times those in higher tax brackets will opt to utilize municipal securities for the added tax benefits.

What are municipal bonds…A muni bond is like any other bond or fixed income investment is a debt instrument. You as the investor loan your money to the issuer for a stated period of time at a specific interest rate. The single biggest difference with the muni market is the potential for tax free income. A municipal bond is generally issued as a debt instrument versus a State, City, County or Local Municipality. The assets collected are used to finance things such as schools, highways, bridges, and various other projects that require funding. They may also be financing the general budget of a municipality.

Generally speaking income derived from a municipal bond is free from Federal income taxes. If the bond was issued by a municipality in the state you reside in for income tax purposes, it will typically be exempt from State income tax as well, should you live in a State that assesses an income tax. If you reside in a state that does not levy an income tax, the Federal exemption on the income applies regardless of which state you purchases the issue from.

General Obligation vs Revenue Bonds

Muni bonds break down into two broad categories with many sub categories. The first of which is the general obligation bond, which is exactly what it states. The issue is not financed by any single project of the municipality. Rather it is funded by the full faith and credit of the municipality and its ability to meet its obligations.

The revenue bond is a bit different. In general they are subject to the ability of a specific project or a specific agency of the municipality. For example should you purchase a bond that was designed to cover the financing of a new bridge to cross the Hudson River and the bridge collapsed, the ability for you to redeem your funds will potentially be in jeopardy. However under such a circumstance the state or city may still be in excellent fiscal condition with no impairment to its ability to repay its debt obligations. For this reason revenue bonds are typically viewed as carrying more risk, which in turn can carry more of an income.

In cases of municipal bonds, there can be other avenues of added protection that you may want when buying an issue. One such feature is insurance. Unlike the Federal Gov’t, a municipality cannot simply create more money when there is a budget shortfall. It is certainly not impossible for a local municipality to go bankrupt. While this is a fairly rare occurrence, it has happened. The bond issuer can issue these debt instruments with an added layer of insurance against a default by a private insurer. There are a relatively small number of companies that specialize in this type of insurance. It should be noted that a bankruptcy in a local municipality does not meet the same definition of an individual bankruptcy and does not usually mean a total loss to the investor. Rather in such instances, the schedule of interest and principal payments may be renegotiated along with the issues duration. Typically a municipality would have to file under the chapter 9 bankruptcy rules.

Another aspect to consider when buying a muni bond is a sinking fund protection. A sinking fund is a separate pool of dollars that are set aside for the purpose of the municipality to retire its debt. This can provide an added layer of protection against the possibility of default.

There are some added tax concerns that too few often realize. In some instances when a revenue bond is purchased, if the bond is issued for certain types of projects that are not considered to be issued for public purposes such as the financing of a new football stadium, the interest may be an added liability in the dreaded Alternative Minimum Tax calculation. When buying the bond, you can inquire about this in advance as to whether or not he bond will be exempted from AMT.

Unlike US treasury issues, most muni bonds typically have what is known as callable feature. This permits the issuer to retire the debt sooner than expected and return to you your principal at specific points in time if it is favorable for the issuer. This can alter your expected return from what you originally anticipated. When buying a muni bond it is important to obtain two seperate quotes. One is yield to maturity, which indicates a rate of return should the bond be held the full duration. The other is yield to call, which indicated a potential return if the issue is retired early.

The bond market in general is a large and fairly complex investment arena with many twists and turns. You need to be keenly aware of the potential markups by your broker dealer as well as issues trading with accrued interest in the secondary market. You should understand whether or not you are buying an issue at a premium or a discount. The municipal market can be a bit more complex in terms of its liquidity risks as well as potential tax implications. In general the average investor is much more likely suited to be using active fund managers and or ETF securities to participate in the fixed income markets. Please see our previous article on Bond vs Bond Funds to further explain…

However should you choose to buy individual muni bonds as a solution for the fixed income portion of your portfolio, hopefully this can provide you with some general information as to what questions may be prudent to ask.


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