Municipal Bonds for the Retail Investor

By Bill Addiss | February 15, 2019

A municipal bond (muni), is a debt security issued by a state, municipality, county or municipal entity to finance its capital expenditures (including construction projects) or for general financing of that municipality. The size and scope of this market is impressive.

There are over 50,000 different issuers of municipal bonds, resulting in over 1 million different issues outstanding in the U.S. In fact, as of 2017, the total value of all municipal bonds was almost $4 trillion. Most municipal bonds are exempt from federal taxes as well as most state and local taxes, which can make them especially attractive to retail investors, particularly those in high income tax brackets. Tweet: Most municipal bonds are exempt from federal taxes as well as most state and local taxes, which can make them especially attractive to retail investors, particularly those in high income tax brackets.

Broadly speaking, there are two types of municipal bonds.

What Are the Two Types of Municipal Bonds?

  • General Obligations (GOs)
  • Revenue bonds (Revs)

What is the Difference Between General Obligation Bonds vs. Revenue Bonds

A general obligation bond (GO) is issued by a state or city and is not backed by revenue from any specific project. Instead, these bonds are backed by the general taxing authority of the municipality which can include, sales tax, property tax and income tax. Therefore, these bonds have multiple sources of revenue (predominantly taxes) backing the security.

By contrast, a revenue bond, (Rev) is a bond which is secured by the revenue generated by a specific project (such as toll roads, bridges, convention centers, stadiums). These bonds are like loans for projects where the bondholders will receive interest and their principal from the revenue generated when the project is completed.

Benefits of Investing in Municipal Bonds

What makes municipal bonds most attractive is the tax status on interest income received. Unlike corporate bonds which are fully taxable to the investor, municipal bonds offer the following tax advantages:

  • Interest Income from most municipal bonds is exempt from Federal Income Tax
  • If the bondholder resides in a state with a state income tax, the municipal bond income can be exempt from state income tax if issued within the buyer’s state of residency
  • If the investor resides in a city with city income tax, interest income can also be exempt from city income tax, also based on the bond buyers residency.

This means the interest income from municipal securities can be triple tax exempt for municipal bondholder, living in a state and city which taxes income, provided they buy a bond issued within the city in which they reside. Of course, if your state has no state income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) the triple tax exemption won’t apply, but you will still enjoy federal tax exemption regardless of what state the bond was issued in. This benefit is enjoyed by those investing in either General Obligation Bonds or Revenue bonds.

For any investor, what’s most important isn’t how much income you earn, but how much you get to keep after taxes. For that reason, municipal bonds offer particular appeal in today’s market.

Bond Yield Illustration:

For example, recently the NY State Turnpike authority issued a 5% coupon municipal bond, maturing in 2032.The bond was A rated by both Moody’s and Standard & Poors.

The question is, how much would an investor have to earn on a taxable investment to equal what they get to keep by earning 5% tax free? The formula for determining theTaxable Equivalent Yield (TEY) is:

Taxable Equivalent Yield = Tax Free Income / (1-Tax Rate)

8.11% = 5% / (1 - .384)

A New York Resident earning $100,000 is in the 38.4% Tax Rate (Fed rate 28% + NY State 6.5% + NY City 3.9% = 38.4%). Using the formula above, we see that a NY Resident would have to earn 8.11% on a taxable investment to equal what they get to keep by earning 5% tax free. Where 5% tax free is achievable in the high quality municipal bond market, 8.11% is not achievable in a similar quality taxable investment like a corporate bond.

Other Bond Considerations:

Insured Bonds

Some municipal bonds are insured or backed by policies written by insurance companies. In the event of default by the issuing municipality, the insurance policy provides for the insurer to pay principal and interest payments to bondholders. Therefore, Investors should take into account the creditworthiness of both the insurer as well as the issuer when considering bonds insured in this manner. In the terminology of the marketplace, these bonds are credit enhanced by the insurance guarantor.

Bond Funds

Because of the almost overwhelming size and scope of the marketplace, many investors often choose to buy municipal bond funds, rather than invest in individual bonds. Because the tax benefit to the investor is based on their residency, the mutual fund industry offers funds that are state specific. For example, a resident of California would want to buy municipal bonds only issued within that state and would therefore invest in a California State Municipal fund. Many mutual fund families offer such state specific funds.

A resident of a state with no state income tax would be most likely to invest in what is called a national series. Since they have no state tax to consider, they can invest in a fund that invests in municipals issued anywhere in the US, not confined to just their state of residence.

How to Buy Municipals

Like all bonds in the US, municipal bonds do not trade on exchanges but rather in the Over-The-Counter (OTC) market. Therefore, to buy individual bonds it is necessary to work with a broker. Most national and regional brokers maintain a daily inventory of municipal bonds which they offer to individual investors. Some states also offer residents the opportunity to buy new issues directly. Additionally, most mutual fund families such as Fidelity, American Funds and Blackrock offer state and national series of municipal bond funds as described above.

The primary regulator for municipal bonds in the US is the MSRB (Municipal Securities Rulemaking Board). They have a very informative website on how to buy municipal bonds and municipal bond funds.

Also, because municipals trade in the OTC market, the regulatory body, Financial Industry Regulatory Authority (FINRA), has certain regulatory oversight as well. They too offer a very informative on-line brochure on how to invest in municipal bonds.

About the Author
Bill Addiss

Bill Addiss develops and facilitates educational programs for a variety of major financial institutions, government agencies and foreign governments. He is the author of multiple financial guides as well as Boycott This Book, an upcoming study of how consumer boycotts have shaped U.S. history.

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