Municipal bonds are debt securities issued by states, cities, counties, and other municipal bodies to support day-to-day obligations as well as capital projects like school construction, highway construction, and sewage construction.
Why would a municipality issue bonds, and why would a private citizen acquire them?
- Municipal bonds (also known as “munis”) are debt securities that are issued by state and local governments.
- These are loans made to local governments by investors to fund public works projects such as parks, libraries, bridges and roads, and other infrastructure.
- Municipal bond interest is frequently tax-free, making them an appealing investment alternative for those in high tax brackets.
- General obligation municipal bonds (GO munis) offer cash flows through project taxes.
They’re usually exempt from federal income tax
Municipal bonds are a popular way to earn tax-free money. They are fixed-income investments that can provide better returns than other alternatives.
The interest on municipal bonds is normally tax-free in the United States. It may even be tax-free in your state or municipality. This benefit allows you to keep a larger portion of your earnings.
Munis are less risky than stocks
Municipal bonds are a low-volatility investing option when compared to other asset classes.
Municipal bond defaults have declined in recent years, so you’re less likely to lose money than if you bought in equities.
What is the primary motivation for businesses and governments to issue bonds?
- They give a steady stream of money. Bonds typically pay interest twice a year.
- Bondholders receive their entire investment back if the bonds are held to maturity, therefore bonds are a good way to save money while investing.
Companies, governments, and municipalities issue bonds to raise funds for a variety of purposes, including:
- Investing in capital projects such as schools, roadways, hospitals, and other infrastructure
What is the purpose of a municipality issuing taxable bonds?
- A taxable municipal bond is a fixed-income security issued by a local government, such as a city, county, or other relevant organization, to fund projects that are not subsidized by the federal government.
- Municipal bonds that are taxable are often used to fund initiatives that do not directly benefit the general public, which is why they are not tax-exempt.
- The majority of taxable municipal bonds are issued to cover deficiencies in state and local pension funds.
Why does a business issue bonds?
Bonds are one way for businesses to raise funds. The investor agrees to contribute the firm a specified amount of money for a specific period of time in exchange for a given amount of money. In exchange, the investor receives interest payments on a regular basis. The corporation repays the investor when the bond reaches its maturity date.
What does it mean for a municipality to issue bonds?
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.
What are the advantages and disadvantages of government bonds?
Government bonds have the advantages of being more secure investments, having tax advantages, and allowing investors to support actual projects. A lower rate of return and interest rate risk are both disadvantages.
What motivates banks to purchase municipal bonds?
Banks, like other investors, buy municipal bonds to take advantage of the tax-free interest they can earn. Commercial banks have traditionally been the primary buyers of tax-exempt bonds. With the passing of the Tax Reform Act of 1986 (the “Act”), presently known as section 265(b) of the Internal Revenue Code of 1986, as amended, banks’ demand for municipal bonds shifted (the “Code”).
The carrying cost (the interest expenditure incurred to purchase or carry an inventory of securities) of tax-exempt municipal bonds is not deductible under the Code. This clause effectively eliminates the tax-free benefit of municipal bonds for banks. The Code makes an exception, allowing banks to deduct 80% of the carrying cost of a “qualified tax-exempt obligation.” Bonds must be I issued by a “qualified small issuer,” (ii) issued for public purposes, and (iii) designated as qualified tax-exempt obligations in order to be qualified tax-exempt obligations. A “qualifying small issuer” is defined as an issuer that issues no more than $10 million in tax-exempt bonds in any calendar year. (1) “Bank qualifying bonds” are a term used to describe qualified tax-exempt obligations.
The Act effectively created two types of municipal bonds: bank qualified (also known as “BQ”) and non-bank qualified (also known as “NQ”).
Although banks are allowed to buy non-bank qualifying bonds, they rarely do so.
The rate they’d need to make the investment profitable would be similar to that of taxable bonds.
As a result, issuers can get cheaper rates by selling bonds to investors who will profit from the tax-free status. Banks, on the other hand, have a voracious need for bank qualifying bonds, which are in short supply. As a result, bank qualified bonds have a lower interest rate than non-qualified bonds.
Any difference in interest rates between bank qualified and non-bank qualified bonds has no bearing on the maturities acquired by banks.
The rate differential between bank qualified and non-bank qualified bonds has only been studied in a few research. According to WM Financial Strategies’ analysis of bond purchase proposals and bids, before to 2008, the rate differential on maturities acquired by banks was generally between 10 and 25 basis points (.10 percent to.25 percent). In general, banks bought bonds with shorter maturities (maturing in ten or fewer years). The rate gap soared to as much as 50 basis points during the credit crisis of 2008, and it was applied to maturities as long as twenty years. The rate differential shrank dramatically after the enactment of the American Recovery and Reinvestment Act of 2009, and was often invisible. (1) After these protections expired, the rate differential reverted to a 10-25 basis point range. The corporation tax rate was decreased from 35 percent to 21 percent with the enactment of the Tax Cuts and Jobs Act of 2017, diminishing the benefit of tax-exempt obligations for banks significantly. WM Financial Strategies believes the benefit of bank qualifying bonds is now less than 10 basis points, based on sales observations.
Any issuer proposing to issue less than $10 million in tax-exempt securities in a calendar year may consider bank qualifying the issue to save on interest costs. Issuers who need more than $10 million may be able to use bank qualification by issuing two series of bonds. For a $20,000,000 loan, for example, two $10,000,000 issues could be sold this year and one next year to get two bank eligible issues. Similarly, for a $25 million financing, $10 million in bank qualifying bonds might be sold this year and $15 million in non-bank eligible bonds could be offered next year.
Prior to separating an issue, a thorough cost analysis should be performed.
First, determine if the interest cost savings from bank qualification will be sufficient to balance the additional issuance expenses associated with two bond issues.
Second, in today’s volatile market, even a short delay in a bond sale can result in much higher interest rates, more than offsetting the rate reduction from bank qualification. For instance, from
From October 7 to December 6, 2010, interest rates increased by about 130 basis points (1.30 percent ).
Interest rates increased by 75 basis points from November 16 to December 16, 2016. (0.75 percent ). As a result, even a short-term postponement of a bond issue could be very costly.
(1)The $10 million bank qualifying bond maximum was increased to $30 million under the American Recovery and Reinvestment Act of 2009 (the “2009 Act”).
Furthermore, borrowers who took part in a pool or borrowed from a conduit issuer that issued more than $30 million in a calendar year were eligible for bank qualifying as long as their total tax-exempt financings were less than $30 million.
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.
Why would a municipal bond issuer seek to buy third-party bond payment insurance?
Bond insurance is a type of credit enhancement provided by a third party. Bond insurance is purchased by a bond issuer to ensure that bondholders are paid if the issuer defaults on a payment. As a result, investors seeking a less volatile investment option will find insured bonds more appealing.