Municipal bonds are issued by states, cities, counties, and other political subdivisions. If you’ve ever wondered how your city funds big projects, municipal bonds are a major part of the answer. Many roads, schools, and parks are built with money borrowed through municipal bond offerings.
National politics gets a lot of attention, but state and local decisions often shape day-to-day life more directly. Money raised in the municipal debt market affects local services, infrastructure, and overall quality of life.
Municipal bonds are typically structured like other bonds. Most pay semiannual interest to investors seeking income. The capital (money) raised through offerings is used to hire employees, expand operations, and build new facilities. One feature that makes municipal bonds stand out is their tax treatment. Interest received from most bonds is taxable, but many municipal bond investors pay no taxes on the interest they receive.
To see why, it helps to compare the tax status of interest across the three main issuer categories:
Corporate bond interest
Corporate bonds generally have the highest tax liability of the three issuer types. This connects directly to yields: because corporate bond interest is taxed at multiple levels, corporate bonds typically offer higher yields than U.S. government and municipal securities. Risk also matters - of the three issuer types, corporate securities generally carry the most risk and the most return potential.
US Government bonds interest
We haven’t covered U.S. government securities yet, but the key tax idea is simple: the interest is taxed by the issuer (the federal government), not by state or local governments. A useful memory aid is that government issuers are the only ones that tax their own securities.
Municipal bond interest
Interest from municipal securities is exempt from federal taxes. Using the same idea as above, the federal government does not tax securities issued by state and local governments.
Although municipal bond interest is subject to state and local taxation, many investors still pay no taxes on municipal bond interest. If you’re a resident of the state that issued the bond, you typically receive interest that is free from state and local taxes as well. For example, a California municipal bond pays tax-free interest to an investor who is a California resident. However, if a Colorado resident buys a California municipal bond, that investor may owe state and local taxes, depending on the rules where they live (some states and cities have income taxes, and some do not). Bottom line - state residents do not pay interest taxes on municipal bonds from their state.
An exception to the residence rule applies to US territory bonds, which are also considered municipal bonds. The US territories are:
Regardless of residence, these bonds are always tax-free to the investor. For example, residents of Alaska who purchase U.S. Virgin Islands bonds receive all interest fully tax-free.
Unlike stock and corporate debt, municipal securities are exempt from many rules and regulations. In particular, municipal issuers are not subject to registration requirements. If a city wants to issue a bond, it is exempt from the SEC’s registration process. In other words, municipalities can raise capital by selling securities without going through SEC registration.
That doesn’t mean the municipal market has no rules. The Municipal Securities Rulemaking Board (MSRB) writes rules and regulations that apply to financial professionals and market participants who work with municipal securities. As its name suggests, the MSRB makes rules, but it does not enforce them. Enforcement is handled by other regulators:
Enforces MSRB rules for securities firms
Enforces MSRB rules for banks
We’ll cover key financial regulators in a future section, but for now, it’s important to know that the MSRB is a self-regulatory organization (SRO). SROs are non-governmental organizations that are authorized by the government to regulate parts of the financial industry. The MSRB’s role is to write rules for the municipal securities market and its participants (firms, registered representatives, and traders). FINRA is also an SRO, but FINRA both writes rules and enforces them.
Throughout this chapter, you’ll see rules and regulations related to municipal securities. These are based on MSRB rules and are enforced by the SEC and FINRA (for non-banking activities). A key point to remember is that these rules apply to market participants - not to the municipal issuers themselves.
In this chapter, we’ll learn about the major types of municipal bonds (general obligation and revenue), other forms of municipal debt, the municipal bond market, and suitability relating to these investments.
We’ll focus on the two primary types of municipal debt for the remainder of this chapter:
General obligation (G.O.) bonds are a common type of municipal bond. They fund important projects for a city, state, or local area that don’t generate revenue. G.O. bonds finance non-self-supporting projects, including schools, roads, parks, and government buildings. A non-self-supporting project does not generate enough revenue to pay for itself.
When a G.O. bond is issued, the municipal government borrows from investors and repays them over time. Because the project itself doesn’t produce revenue to repay the debt, the municipality uses taxes to repay the borrowed funds. Specifically, G.O. bonds are typically repaid with property taxes.
Each year, property owners receive a tax bill from their local government based on the value and type of property they own. Property taxes, also called ad valorem taxes, support many local services, including school districts, police departments, park maintenance, and city libraries. If a municipality wants to fund a new non-self-supporting project, it can raise money through a G.O. bond offering, pay for the project, and then use property taxes to repay investors over time.
G.O. bonds are typically not backed by specific collateral. Instead, they are backed by the full faith, credit, and taxing power of the municipality. Full faith and credit bonds are generally not as safe as secured bonds, but a municipality’s taxing power is a major support. If a state or local government is short of funds needed to pay debt service on a G.O. bond, it can raise property taxes with voter approval.
Raising taxes isn’t always a complete solution, though. Factors such as population trends, economic diversity, and existing municipal obligations can affect an issuer’s ability to repay G.O. bonds. For example, the city of Detroit filed for bankruptcy in 2013, which remains the largest municipal bankruptcy filing in US history. Contributing factors included a declining population, reliance on a single dominant industry (the auto industry), and significant pension obligations.
When a municipality’s population declines, the local government loses taxpayers. That’s why local leaders often try to attract residents and businesses: more people generally means a larger tax base.
A single dominant industry can also create vulnerability. Detroit grew around the automobile industry. When the industry was strong, it supported a booming local economy with stable jobs and good wages.
By the Great Recession of 2008, conditions had changed. The economy experienced the largest financial collapse since the Great Depression in the 1920s and 1930s. During economic downturns, consumers often delay purchases of durable goods such as automobiles.
Auto sales plunged in 2008 and 2009, creating major problems for Detroit. Because so much of the local economy depended on the auto industry, business closings and layoffs affected large portions of the population. Over the following years, many residents left the city to find opportunities elsewhere, which further reduced the tax base.
Municipalities can also be strained by large long-term obligations, such as pensions. Pensions are retirement plans that today are generally offered only by government entities. Under a pension plan, a retiree receives an ongoing benefit for life after meeting service requirements (often at least 20 years). Benefits are commonly based on a percentage of the worker’s earnings (for example, 80% of the worker’s highest year of earnings) and continue until death.
Pensions provide lifetime retirement income, but they can be costly for employers. A municipality must continue making pension payments even during financial stress. In Detroit’s case, pension payouts added to the city’s financial strain in the late 2000s and early 2010s.
In summary, G.O. bonds fund state and local projects that don’t generate their own revenue. Repayment depends on the municipality’s ability to collect property (ad valorem) taxes. Factors such as a larger population and a more diverse local economy can support credit quality, while large obligations (like pensions) can make repayment more difficult.
Municipal revenue bonds fund projects that generate revenue. If your city operates a facility that brings in money, it was likely financed - at least in part - through a revenue bond issue.
Toll roads, airports, stadiums, city zoos, convention centers, and water treatment plants are common examples. These projects serve the community, and they also produce operating revenue.
Before issuing a revenue bond to fund a project, a municipality typically evaluates whether the project can generate enough revenue to support the debt. Suppose a city wants to build an aquarium that will charge admission. The aquarium will cost millions of dollars, and taxpayer money won’t be available for it. To estimate the project’s earning potential, the municipality hires independent consultants to prepare feasibility studies. These reports help determine whether the project or facility is likely to be profitable.
If the feasibility study forecasts a profitable aquarium, the city can move forward with construction. A self-supporting revenue bond is issued to the public, and the capital (money) raised is used to build the aquarium. The aquarium’s revenues are then used to pay interest and repay principal over time. Most revenue bonds are considered self-supporting because they do not rely on taxes to repay borrowed funds.
Because revenue bonds are not repaid with taxpayer funds, they do not require voter approval to be issued. For the same reason, revenue bonds are not subject to debt limits either.
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