Who Holds 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 difference0.4 percentage pointsis 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.

Municipal bonds are issued by who?

Municipal securities, or “munis,” are bonds issued by states, cities, counties, and other government bodies to raise funds for public projects such as roads, schools, and other infrastructure.

Munis pay a predetermined amount of interest (typically semiannually) and refund the principle on a predetermined maturity date. The majority of municipal bonds are offered in $5,000 increments and have maturities ranging from 2 to 5 years to very long (30 years).

When considering a municipal bond investment, keep in mind that no two municipal bonds are alike, and carefully assess each one, making sure to get the most up-to-date information on both the bond and the issuer. See FINRA’s Investor Alert Municipal BondsImportant Considerations for Individual Investors for further information.

Buying and Selling Munis

Some municipal bonds have a higher level of liquidity than others. Some bonds trade frequently, while others may go weeks without any activity (no interested buyers or sellers). Municipal bonds, in general, are more susceptible to supply and demand pressures than other fixed-income securities. As a result, you’re taking on more market risk: If your bond is out of favor with other investors when you need to sell it, the price you get in the secondary market will fall. Of course, munis, like all bonds, are susceptible to interest rate risk: if rates rise faster than your bond’s rate, the bond’s secondary market value drops.

Because of the overwhelming amount of muni bonds available and the tremendous competition among dealers for a piece of the pie, muni investment should be approached with caution. Do your homework, beginning with selecting an investment professional with a track record of success in municipal securities.

Munis and Taxes

The principal reason why most private investors purchase municipal bonds is to benefit from preferential tax treatment on the interest they earn. The great majority of municipal bond interest is tax-free in the United States. Indeed, municipal securities are the only ones that fall within this category.

Furthermore, if you live in the state or city that issued the bond, your interest income may be exempt from state or city taxes. Residents of all states are excluded from paying taxes on bonds issued by Puerto Rico, Guam, and other US territories.

The federal government does not exclude all municipal bonds from taxation. Municipal bonds that are taxable may be issued to fund projects that the federal government would not fund. To make up for the lack of a tax advantage, these bonds often have higher yields than tax-exempt municipal bonds, and are more in line with corporate or agency bond rates.

The AMT (alternative minimum tax) is a tax that some persons must pay. The AMT is calculated using a separate set of principles than your regular income tax calculation, but you must pay whichever calculation is higher. The AMT may apply to investors who buy “private activity” municipal bonds, which are bonds that aren’t solely used for government activities. Interest gained on these “private activity bonds” cannot be deducted under AMT rules, unlike interest earned on other municipal bonds, including 501(c)(3) private activity bonds, and may result in an AMT payment. Before advising a tax-exempt investment, a reputable financial adviser should assess your AMT liabilities. A tax professional’s counsel is also recommended.

Who buys municipal bonds and why?

Municipal bonds (munis) are issued by state, county, and local governments to support public works projects such as road maintenance and other construction projects. Investors should consider the tax-equivalent yield when deciding whether municipal bonds are a better investment than taxable bonds or CDs.

Who is responsible for municipal debt?

According to Census Bureau data from 2013, the total debt held by municipal governments is less than $2 trillion.

Municipal securities are regarded as the second-riskiest investment asset after Treasuries.

State and local governments are the primary issuers of municipal securities, which are used to fund infrastructure and capital needs. State and municipal governments, as well as other government agencies, may issue bonds for a variety of reasons, including transactions in which the proceeds are borrowed by non-profit institutions (such as health care and higher education) and for economic growth.

There are around 1.5 million municipal bonds outstanding with a total value of $2.9 trillion, with private investors owning 70% of them. Each year, almost 12,000 issuances are completed.
Municipal securities existed before the federal income tax was enacted. When the federal income tax was enacted, income from municipal bond interest was specifically exempt from federal taxation. In addition, several states exempt income earned on municipal securities purchased within their borders from taxation.
State and municipal governments are banned from charging the interest on federally issued bonds due to the reciprocal immunity concept between the federal government and state and local governments.
Non-GO debt is issued by governments and special entities and is usually backed by a specific revenue source (special taxes, fees, or loan repayments) associated with the enterprise or borrower. General Obligation, or GO Debt, is backed by the full faith and credit (taxing power) of a general purpose government like a state, city, or county.
There are two sorts of defaults: (1) minor “technical defaults,” in which a bond covenant is broken but no payment is missed and the bond structure remains unchanged, and (2) defaults, in which a bond payment is missed or debt is restructured at a loss to investors.
Only 54 defaults (excluding technical defaults) have occurred in the municipal sector since 1970, with only four of these defaults coming from city or county administrations; the remaining 78 percent originated from health-care and housing-related projects issued by special organizations. (Moody’s)
Historically, the entire municipal sector has had a default rate of less than 1/3 of one percent, compared to a corporate default rate of more than ten percent (Fitch). This default rate is far lower than the default rate on corporate bonds. Between 1970 and 2006, the default rate for triple-A municipal bonds was 0%, compared to 0.52 percent for triple-A corporate bonds. (Moody’s)
No state has defaulted on its debt in the last century, with the exception of Arkansas in 1933. It’s worth noting that bondholders in Arkansas were paid in full when the state defaulted in 1933.
The recovery rate for governmental debt is higher than the recovery rate for corporate debt, with a recovery rate of 100% for general obligation and tax-backed debt.
Reports of an increasing number of defaults in the state and local government sector are unfounded, as are current budget predictions and economic data.
Debt service accounts for just approximately 5% of state and local governments’ general fund expenditures.
The majority of debt is issued for capital projects, such as the building or improvement of schools, streets, highways, hospitals, bridges, water and sewer systems, ports, airports, and other public works, rather than for operational budgets.
Most state and local governments follow a typical practice of paying debt payment first, then all other expenses; in some situations, this is required by law or legislation.
The jurisdictions in numerous municipal bankruptcy have not defaulted on their debt/municipal bonds, protecting investors (including the largest in history-Orange County, CA in 1994).

“Facts You Should Be Aware Of.” NLC, NGA, NCSL, CSG, NACo, USCM, ICMA, NASBO, NASACT, GFOA, and NASRA collaborated on a fact sheet. The month was February of 2011.

Bureau of the Census, 2013 State and Local Government Finances, http://factfinder.census.gov/faces/tableservices/jsf/pages/productview.xhtml?src=bkmk

What is the yield on municipal bonds?

You can invest in either ordinary corporate bonds or tax-exempt municipal bonds. Corporate bonds have a yield of 7%, while tax-free municipal bonds have a yield of 5%.

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.

What is the source of bond money?

A bond is just a debt that a firm takes out. Rather than going to a bank, the company obtains funds from investors who purchase its bonds. The corporation pays an interest coupon in exchange for the capital, which is the annual interest rate paid on a bond stated as a percentage of the face value. The interest is paid at preset periods (typically annually or semiannually) and the principal is returned on the maturity date, bringing the loan to a close.

Do municipal bonds pay monthly interest?

Municipal bonds (also known as “munis”) or tax-exempt bonds are examples of such bonds. The majority of municipal bonds and short-term notes are issued in $5,000 or multiples of $5,000 denominations. Interest on bonds is usually paid every six months (though some forms of bonds work differently), while interest on notes is usually paid when the note matures.

Is municipal bond interest taxable?

Residents of the issuing state are generally excluded from federal and state taxes on income earned from municipal bonds. While interest income is tax-free, any capital gains delivered to the investor are taxable. The Federal Alternative Minimum Tax may apply to some investors’ earnings (AMT).

What is causing the decline in municipal bond funds?

Some economists predict a reduction in muni demand this year due to a predicted slowing in household savings, which grew during the pandemic, particularly among the wealthy. The demand for tax-exempt debt has long outstripped annual issuance.