Munis offer investors a less taxing way to earn bond income.

Municipal bonds, widely known as munis, are a way for governments below the federal level, such as states, cities, and counties, to raise money. Their major appeal for investors is their tax treatment. In most cases, muni interest isn’t subject to federal income tax, though there are some exceptions.

If you invest in your own state’s munis, the income is usually free of state tax, too. The same goes for the munis of your own city or county. So even though munis may offer a lower coupon rate than comparable taxable bonds, the tax break can push their value higher, especially if you’re in a higher tax bracket. You do take certain risks when you buy munis, however.

Bonds with longer maturities are vulnerable to interest rate risk, which would mean receiving less than par if you sold. Inflation risk could reduce the buying power of the interest you earn. Also, some munis can be called, or redeemed by the issuer, before maturity.

Who issues bonds?

State, county, and local governments issue bonds to fund ongoing activities, new projects, and improvements. So do other public enterprises and authorities, such as public hospitals, toll roads and bridges, universities, and public utilities. When these municipalities or municipal agencies issue bonds, they release an official statement (OS) to investors, containing all the details about the bond — including how the issuer plans to raise the cash to pay its debt.

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If the interest will be paid out of tax revenues, the muni is a general obligation (GO) bond. If the bond will be paid with specific fees collected by the issuer —such as the tolls on a bridge — it’s called a revenue bond. Sometimes an issuer uses a combination of taxes and fees to pay for a bond, known as a double-barreled bond. Although some investors consider GO bonds safer than revenue bonds, it’s rarely wise to generalize.

Interest on many revenue bonds is paid with regular, predictable fees for services that are in constant demand, such as bridge tolls or airport departure fees. And some GO bonds are issued by governments in dire fiscal circumstances that can’t raise enough in taxes to meet their obligations. Before you invest, it’s best to review each bond on its own merits.

WHO INVESTS IN MUNIS?

Big institutional investors like pension funds, mutual funds, and life insurance companies don’t dominate the muni market as they do other bond markets. So muni underwriters tend to cater to individual investors, in part by making it possible to make an investment in the $5,000 to $10,000 range. Another advantage of muni investing is that prices tend to be relatively stable, since individuals are less likely than institutions to trade bonds before maturity.

Tax exceptions

Not all munis are tax exempt. Some, called taxable munis, are subject to federal income tax. They’re issued by governments on behalf of private enterprises that don’t provide qualifying public services. For example, proceeds from a taxable muni may be used to build a sports stadium or a shopping mall. Other munis that are exempt from ordinary federal income tax are subject to the alternative minimum tax (AMT). About 9% of munis fall into this category, because the tax law defines them as private-purpose bonds. They’re used to fund non-governmental projects like housing and airports.

You’ll also have a taxable capital gain if you sell the bond at a higher price than you paid to buy it. The same is true if you buy a muni at a discount and redeem the bond at par. If you’ve held the bond for more than a year, you canigure the tax at your long-term capital gains rate, which is determined by your adjustable gross income (AGI).

Municipal Bonds

Why munis ratings are so important?

Better credit quality can mean greater investor demand and lower coupon rates. And the lower the rate, the less borrowing costs. So municipalities have found ways to improve the credit rating of their bonds. One way is through bond insurance, which guarantees coupon and principal payments. If the issuer defaults, the insurer makes the payments.

The companies that insure municipal bonds assess the credit quality of the issuer before agreeing to the coverage. In that sense, investors may consider bond insurance to be an expert second opinion on credit risk. While bond insurance may help protect you from the credit risk of a municipal default, it doesn’t protect against interest rate risk. Keep in mind, however, that if these insurers suffer major losses on other investments they have guaranteed, they may have trouble meeting their obligations on a municipal bond default.

IT’S A TEAM EFFORT

Municipals’ advisers work with governments to create borrowing plans, collaborate on determining the details of new issues, represent their interests in negotiations with underwriters, and help to prepare disclosure documents. These advisers, who are overseen by the Municipal Securities Rulemaking Board (MSRB), have a fiduciary responsibility to act in the best interests of their clients.

The credit quality of municipal bonds tends, overall, to be higher and the default rate lower than for corporate bonds. When rating agencies are assessing municipal credit risk, one element they look at is a ratio known as debt coverage — how much money an issuer has available for its debt divided by the amount it owes. If that ratio is below 1 then the rater concludes that the issuer doesn’t have the money to cover the debt. A debt coverage ratio of 2 is considered good, and of 4 or higher, excellent.

Municipal bonds offerings

Municipalities seeking capital may bring bonds to market in two ways: through a negotiated arrangement or a competitive bid. In a negotiated arrangement, the issuer works with a securities firm — often the same one over a period of years. The firm underwrites the issue and guarantees a presale. In a competitive bid, the issuer is obligated to choose the firm that submits the lowest price for its services. In many states, the law requires competitive bidding in the issue of general obligation bonds.

Understanding Municipal Bonds, Its Rating And Offerings by Inna Rosputnia

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