Municipal Bonds 101

Municipal Bonds (Munis) are issued by municipalities to fund local government activities such as construction projects, bridges, the repaving of major highways, etc.

A key feature of munis is that the federal government cannot tax interest on state bonds (and vice versa). In addition, a state government will often exempt its citizens from state and local taxes (known as triple tax-free status) to encourage investors to purchase municipal bonds for the good of the community

Municipal bonds are in constant demand due to their tax benefits. For this reason, munis generally offer a lower coupon rate than equivalent taxable bonds. In addition, they are not as actively traded as treasuries. Thus, bid-ask spreads are often wider. Overall, price movements are not as volatile as treasuries. However, economic stimuli and changes in supply-demand equilibrium can lead to significant changes in value.

General Obligation Bonds (GOs)

A General Obligation Bond is a common form of municipal bond. GOs are backed by the taxing power of the issuing government. Taxpayer dollars are used to meet interest and principal payments. Like corporate bonds, issuers of GOs are monitored by credit rating agencies. The better the issuer’s credit rating, the less risk is perceived and the smaller the interest rate the issuer will have to offer to attract investors. Many investors regard general obligation bonds as safer than project-specific munis (See Revenue Bonds) because a local government is less likely to experience financial strains than a construction project, hospital, etc.

Revenue Bonds (Revs)

Another common municipal bond is the Revenue Bond. Revenue bonds are generally backed by the future revenue stream of a specific project. The proceeds earned from issuing revenue bonds are used to finance the project. However, revs are sometimes issued to fund projects without substantial revenue streams. In these situations, the bonds are secured through the income stream of another project or entity. Like general obligation bonds, revenue bonds are monitored by credit rating agencies.

Evaluating Municipal Bonds

Investors often need to compare the yields between tax-free municipal bonds and taxable coupon bonds. To do this, investors convert the yield of a tax-free municipal bond into a taxable equivalent yield derived as follows:

Consider the following example: Calculate the taxable equivalent yield of a municipal bond yielding 4.9% (Assume a 15% tax bracket).

TEY = .049 / (1 – .15) = .0576 or 5.76%

Thus, an investor would need to earn a yield of 5.76% on a taxable bond to earn a return equal to that of the municipal bond. 

The following chart details the advantages and disadvantages of Municipal Bonds:

Questions:

1.  Explain the difference between a general obligation bond and a revenue bond.

2.  Calculate the taxable equivalent yield of a municipal bond yielding 3.4% (Assume a 10% tax bracket).

   a.  3.12%
   b.  3.74%
   c.  3.78%
   d.  3.89%

3.  Calculate the taxable equivalent yield of a municipal bond yielding 5.7% (Assume a 24% tax bracket).

   a.  7.50%
   b.  7.20%
   c.  6.78%
   d.  8.19%

Answers

1.    Reference

2.    C

3.    A

All Tutorials © 2004
The Brookline Group, LLC
All Rights Reserved

Terms of Use │ Privacy Policy │ Contact