Municipal bonds (also known as municipal debt) are a type of debt “State, city, county, and other local agencies issue debt securities to support day-to-day commitments as well as capital projects such as the construction of schools, roadways, and sewer systems. When you buy municipal bonds, you’re effectively lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or a combination of the two “I am the principle.” The maturity date of a municipal bond (the day on which the bond’s issuer repays the principal) could be years away. Short-term bonds will mature in one to three years, whereas long-term bonds will take a decade or more to maturity.
Municipal bond interest is generally tax-free in the United States. If you live in the state where the bond was issued, the interest may be free from state and local taxes. Bond investors are often looking for a consistent stream of income payments and, when compared to stock investors, are more risk conservative and concerned with preserving rather than developing capital. Due to the tax benefits, tax-exempt municipal bonds typically have lower interest rates than taxable fixed-income assets such as corporate bonds with equal maturities, credit quality, and other characteristics.
- States, cities, and counties issue general obligation bonds that are not backed by any assets. General obligations, on the other hand, are backed by the government “the issuer’s “full faith and credit,” which includes the ability to tax inhabitants in order to pay bondholders.
- Revenue bonds are backed by earnings from a specific project or source, such as highway tolls or lease fees, rather by the government’s taxing power. Some revenue bonds are available “The term “non-recourse” refers to the fact that bondholders have no claim to the underlying revenue source if the revenue stream ceases to exist.
Municipal borrowers also occasionally issue bonds on behalf of private businesses such as non-profit universities and hospitals. The issuer, who pays the interest and principal on the bonds, often agrees to reimburse these “conduit” borrowers. The issuer is usually not compelled to pay the bonds if the conduit borrower fails to make a payment.
Where can investors find information about municipal bonds?
The Municipal Securities Rulemaking Board’s Electronic Municipal Market Access (EMMA) website makes municipal securities documentation and data available to the public for free. You will have access to:
- Economic reports and events that may have an influence on the municipal bond market are listed on this calendar.
It’s worth noting that many issuers have dedicated websites or webpages for municipal bond investors. Some issuers link to those pages from their EMMA main page. Learn how to use EMMA to locate issuer homepages.
In 2009, the Securities and Exchange Commission recognized EMMA as the official depository for municipal securities disclosures. The MSRB is supervised by the Securities and Exchange Commission (SEC). The MSRB is a self-regulatory body whose objective is to promote a fair and efficient municipal securities market in order to safeguard investors, state and local governments, and other municipal entities, as well as the public interest. The disclosure materials are not reviewed by the SEC or the MSRB before they are posted on EMMA.
What are some of the risks of investing in municipal bonds?
Municipal bonds, like any other investment, carry certain risk. Municipal bond investors are exposed to a number of dangers, including:
Call it a gamble. Call risk refers to the possibility of an issuer repaying a bond before its maturity date, which could happen if interest rates fall, similar to how a homeowner might refinance a mortgage loan to take advantage of reduced rates. When interest rates are constant or rising, bond calls are less likely. Many municipal bonds are “callable,” thus investors who plan to hold a bond to maturity should look into the bond’s call conditions before buying it.
There is a credit risk. This is the risk that the bond issuer will run into financial difficulties, making it difficult or impossible to pay interest and principal in full (the inability to do so is known as “default”). For many bonds, credit ratings are available. Credit ratings attempt to measure a bond’s relative credit risk in comparison to other bonds, yet a high grade does not imply that the bond would never default.
Interest rate risk is a concern. Bonds have a set face value, which is referred to as the “par” value. If bonds are held to maturity, the investor will get the face value of the bond plus interest, which might be fixed or variable. The market price of the bond will grow as interest rates fall and fall as interest rates rise, hence the market value of the bond may be greater or lesser than the par value. Interest rates in the United States have been historically low. If interest rates rise, investors who hold a cheap fixed-rate municipal bond and try to sell it before it matures may lose money due to the bond’s lower market value.
There is a chance of inflation. Inflation is defined as a widespread increase in prices. Inflation diminishes purchasing power, posing a risk to investors who are paid a fixed rate of interest. It may also result in higher interest rates and, as a result, a decrease in the market value of existing bonds.
There’s a danger of running out of cash. This refers to the possibility that investors may be unable to locate an active market for the municipal bond, prohibiting them from buying or selling the bond when they want and at a specific price. Because many investors purchase municipal bonds to hold rather than trade them, the market for a given bond may be less liquid, and quoted values for the same bond may range.
In addition to the risks, what other factors should you consider when investing in municipal bonds?
There are tax implications. Consult a tax specialist to learn more about the bond’s tax ramifications, such as whether it’s subject to the federal alternative minimum tax or qualified for state income tax benefits.
Brokerage commissions. The majority of brokers are compensated by a markup on the bond’s cost to the firm. It’s possible that this markup will be revealed on your confirmation statement. If you are charged a commission, it will appear on your confirmation statement. You should inquire about markups and commissions with your broker.
How do municipal bonds get paid?
While most municipal bonds pay interest on a regular basis, a zero-coupon bond only pays out once at maturity. You buy zeros at a discount, which means you pay less than the bond’s face value. The difference between the purchase price and the face value of a zero when it matures is the return on your investment.
How are municipal bonds paid off?
Municipal bonds are worth considering if your primary investing goal is to protect capital while receiving a tax-free income stream. Municipal bonds (also known as munis) are debt obligations issued by government agencies. When you purchase a municipal bond, you are essentially lending money to the issuer in exchange for a specified number of interest payments over a set period of time. When the bond reaches its maturity date at the end of that time, you will receive the whole amount of your initial investment back.
Bonds are paid for by taxpayers.
Putting “no tax increase” in front of “bonds” is designed to dampen opposition to increased taxes, as it is with many political words. But, to be clear, there is no category of bonds issued by school districts that does not result in an increase in your taxes. Bonds with no tax increase raise your taxes.
How? Bonds are frequently issued by school districts to fund capital projects such as the construction of new facilities or the renovation of existing infrastructure. The bonds are paid off over time by the taxpayers, usually through an increase in their property taxes. Bonds are issued for a set period of time, and when they are paid off, the tax payments of the taxpayers are reduced.
How do municipalities make use of municipal bonds?
Roads, bridges, airports, schools, hospitals, water treatment facilities, power plants, courthouses, and other public structures are examples of significant, expensive, and long-term capital projects for which state and municipal governments issue bonds. State and municipal governments can, and do, pay for capital investments using current income, but borrowing allows them to spread the expenses across numerous generations. Future users of the project pay a portion of the cost through rising taxes, tolls, fares, and other fees that help pay off the obligations.
To assist smooth out unbalanced financial flows, states and municipalities issue short-term loans or notes (e.g., when tax revenues arrive in April but expenditures occur throughout the year). They also issue debt for private companies (e.g., to build projects with public benefit or for so-called public-private partnerships).
HOW LARGE IS THE MUNI BOND MARKET?
State and local governments had $3.85 trillion in debt at the end of 2019. (figure 1). Approximately 98 percent of this debt was long term, having a maturity of at least 13 months, while only 2% was short term. As in previous years, states issued around 40% of municipal debt while local governments issued 60%.
Municipal debt has more than tripled in nominal terms since the mid-1980s, but the shift as a proportion of GDP has been less significant.
What Are the Main Types of State and Local Government Debt?
General obligation bonds are backed by a company’s “full faith and credit,” which includes the ability to tax. Future revenue streams, such as dedicated sales taxes, tolls, and other user charges generated by the project being financed, may also be used to secure bonds.
Generally, general obligation bonds require voter approval and are subject to debt-to-equity limitations. These rules and limits do not apply to revenue bonds or bonds secured by projected legislative appropriations. In 2018, revenue bonds accounted for 58 percent of state and municipal issuances, general obligation bonds for 36%, and private placements for 6%.
Who Holds State and Local Government Debt?
Households hold the majority of state and municipal bonds, followed by mutual funds (which also represent household investors) (figure 3). Until the Tax Reform Act of 1986 and subsequent lawsuits, banks and life insurance corporations were the most major municipal bond holders.
How Does the Federal Tax Exemption Work and What Are Proposals for Reform?
The federal income tax has exempted interest payments from municipal bonds from taxable income since its introduction in 1913. Interest on bonds issued by the taxpayer’s home state is usually free from state and municipal taxes. In Department of Revenue of Kentucky v. Davis, the US Supreme Court maintained states’ power to tax interest on bonds issued by other jurisdictions.
For a given degree of risk and maturity, state and local governments can borrow more cheaply than other debt issuers, such as companies, thanks to the federal tax exemption. As a result, the federal tax exemption acts as a federal subsidy for state and municipal infrastructure spending. This subsidy comes with a price tag of $28 billion in lost tax income in fiscal year 2020.
The federal tax exemption has been criticized as wasteful since it provides high-income taxpayers with more than the required incentive to buy municipal bonds. A high-grade tax-exempt municipal bond, for example, yielded 3.53 percent in 2018. A comparable taxable corporate bond yielded 3.93 percent. As a result, taxpayers with a federal tax rate of around 10% should be able to choose between the two types of bonds (the yield difference—0.4 percentage points—is roughly 10% of 3.93 percentage points). Anyone in a higher tax bracket earns a windfall, while the borrower receives no further advantage.
Because of this inefficiency, ideas to reduce the federal tax exemption have long circulated, most recently by former Vice President Joe Biden as part of his 2020 campaign tax proposals. However, whether states and localities respond by issuing more or fewer bonds, and whether bondholders respond by changing their portfolios toward taxable bonds or other investments, will determine the revenue benefit from eliminating or reducing the deduction (Poterba and Verdugo 2011). It’s also difficult to keep all key bond characteristics constant, such as risk, maturity date, fixed versus variable interest payments, and liquidity (Congressional Budget Office and Joint Committee on Taxation 2009).
Notably, the bond interest exemption has not been capped in any of President Donald Trump’s previous budget plans.
In 2021, are municipal bonds a decent investment?
- Municipal bond interest is tax-free in the United States, however there may be state or local taxes, or both.
- Be aware that if you receive Social Security, your bond interest will be recognized as income when determining your Social Security taxable amount. This could result in you owing more money.
- Municipal bond interest rates are often lower than corporate bond interest rates. You must decide which deal offers the best genuine return.
- On the bright side, compared to practically any other investment, highly-rated municipal bonds are often relatively safe. The default rate is quite low.
- Interest rate risk exists with any bond. You’ll be stuck with a bad performer if your money is locked up for 10 or 20 years and interest rates climb.
When a city sells bonds, what happens?
If you invest in city bonds, you will receive a tax credit from federal and some state income taxes, but your investment will not always be free of additional tax burdens, such as:
- State taxes are levied. If you invest in a bond issued by a state other than your own, you’ll usually have to pay taxes on the interest you earn. However, if you invest in a bond issued by your home state, the interest income you earn is normally exempt from state taxes. This isn’t always the case, though. For resident taxpayers, certain states levy taxes on certain types of bonds.
- Taxes on the federal level. Some municipal bonds are not tax-exempt at the federal level. A bond, for example, could be issued to assist fund a failing pension plan.
- De minimis taxes are taxes that are imposed on a small scale. You may owe taxes on the difference between the amount you paid and the bond’s market value, or par value, if you buy a bond at a discount.
- AMT stands for alternative minimum tax (AMT). Some municipal bond interest income is subject to the AMT liability. This calculation is frequently intricate and difficult to comprehend for the majority of taxpayers. A tax specialist can help you sort through the muck on this one.
- Social Security payouts are subject to a higher tax. Municipal bond interest income is included in your modified adjusted gross income (MAGI) by the IRS, which may increase your Social Security tax liability.
- Medicare rates are going up. Your MAGI may increase the amount you pay for Medicare Part B or Medicare prescription medication coverage as a result of your interest income from municipal bonds.
- There is a tax on capital gains. You must pay tax on the amount of gain realized if you sell a municipal bond before its maturity date and get a payment that is larger than your purchase price, adjusted for paid premiums and obtained discounts.
What bonds are free from federal taxes?
Federal income from state, city, and local government bonds (municipal bonds, or munis) is normally tax-free. However, you must record this income when you file your taxes.
In most cases, municipal bond income is tax-free in the state where the bond was issued. However, take in mind the following:
- Occasionally, a state that normally taxes municipal bond interest would exempt special bonds when they are issued.
Municipal bond income may potentially be free from local taxes, depending on your state’s regulations. For further information on the rules in your state, see a tax advisor.
Which government bonds are exempt from taxes?
A government entity issues tax-free bonds to raise revenue for a specific purpose. Municipal bonds, for example, are a type of bond issued by municipalities. They have a fixed rate of interest and rarely default, making them a low-risk investment option.
The most appealing aspect, as the name implies, is the absolute tax exemption on interest under Section 10 of the Income Tax Act of India, 1961. Tax-free bonds often have a ten-year or longer maturity period. The money raised from these bonds is invested in infrastructure and housing initiatives by the government.
How do bonds get their money?
Simply put, a bond fund is a mutual fund that only invests in bonds. A bond fund is a more efficient way of investing in bonds for many individuals than buying individual bond instruments. In addition, participants indirectly participate in the interest paid by the mutual fund’s underlying bond instruments.