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 to investors is their tax treatment. In most cases, muni interest isn’t subject to federal income tax, though some exceptions exist.

What is a municipal bond and how does it work?

Municipal bonds are bonds issued by various cities, states, and other local governmental organizations to provide public services or finance public initiatives.

Municipal bonds can have tax benefits but have slightly lower interest rates than corporate 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.

The muni is a general obligation (GO) bond if the interest is paid out of tax revenues. However, 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.

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Interest on many revenue bonds is paid with regular, predictable fees for services 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 taxes to meet their obligations.

Municipalities seeking capital may bring bonds to the 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 the years. The firm underwrites the issue and guarantees a presale. In a competitive bid, the issuer must choose the firm that submits the lowest price for its services. In many states, the law requires competitive bidding on the issue of general obligation bonds.

What are the risks of investing in municipal bonds?

Municipal bonds are a good option for people who want to protect their cash while also producing a tax-free source of income. Buying municipal bonds is low-risk, but certain risks are still involved.

For example, bonds with longer maturities are vulnerable to interest rate risk, which would mean receiving less than par if you sold. In addition, inflation risk could reduce the buying power of your interest. Also, some munis can be called, or redeemed by the issuer, before maturity. There are clauses in many municipal bonds that permit the issuer to call or redeem the bond before the actual maturity date. For example, when market interest rates decline, an issuer would often call bonds, allowing the corporation to reissue them at a lower borrowing cost. In addition, bond issuers occasionally call bonds to change an indenture through a new offering.

The vast majority of municipal bonds are not regularly traded. Therefore, the probability of discovering a particular municipal bond in the secondary market at any given time is comparatively low.

The majority of municipal bonds have fixed interest rates. Throughout the bond’s life, this rate remains constant. Therefore, prices for municipal bonds on the secondary market are influenced primarily by changes in interest rates and expectations of future interest rate rises or falls.

Why are munis ratings so important?

Better credit quality can mean greater investor demand and lower coupon rates.

Municipal Bonds

And the lower the rate, the lower the 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 issuer’s credit quality 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.

Overall, the credit quality of municipal bonds tends to be higher, and the default rate is lower than for corporate bonds. When rating agencies assess municipal credit risk, they look at 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, 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 4 or higher is excellent.

Are municipal bonds tax-free?

Not all munis are tax-exempt. Some, called taxable munis, are subject to federal income tax. Governments issue them 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 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. As a result, 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 configure the tax at your long-term capital gains rate, which is determined by your adjustable gross income (AGI).

Why invest in municipal bonds?

The interest you receive from your tax-exempt municipal securities is often tax-free, but it may not always be. For example, if you invest in your own state’s munis, the income is usually free of state tax. The same goes for the munis of your 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.

Municipal bankruptcies and defaults can and do happen, but compared to the corporate bond market, they have been comparatively rare. 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 by making it possible to invest 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.

Understanding Municipal Bonds, Its Rating And Offerings by Inna Rosputnia

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