Types

Municipal bonds are issued by states, cities, counties, and political subdivisions. If you have ever wondered how your city funds itself, municipal bonds play a crucial role. Your city and state roads, schools, and parks were most likely built with money borrowed through a municipal bond.

Although many of us pay attention to national politics, it’s what happens at our state and local levels that tend to influence our daily routines the most. Money raised in the municipal debt market has a direct impact on local resources and quality of life.

Municipal bonds are typically structured like normal bonds. Most pay semi-annual interest to investors seeking income. Capital (money) raised through offerings is used to hire employees, expand operations, and build new facilities. However, there is one unique aspect of municipal bonds that involves taxes. Normally, interest received from bonds is taxable. However, many municipal bond investors pay no taxes on interest received. Let’s first establish the tax status of all three categories of issuers:

Corporate bond interest

• Subject to federal, state, and local taxes

Corporate bonds have the highest tax liability of the three issuer types This relates directly to yields. Due to the high level of taxes assessed on corporate bonds, they have higher yields than US Government and municipal securities. Risk is also a factor; of the three issuer types, corporate securities come with the most risk and most return potential.

US Government bonds interest

• Subject to federal taxes
• Exempt from state and local taxes

We haven’t learned about US Government securities yet, but the interest paid on these securities is taxed by their issuer (the federal government), not by state or local governments. There’s an easy way to remember this - when it comes to government issuers, they are the only ones that tax their own securities.

Municipal bond interest

• Exempt from federal taxes
• Subject to state and local taxes

Interest from municipal securities is exempt from federal taxes. Remember, governments are the only ones that tax their own securities. Other levels of government (in this case, the federal government) do not.

Although municipal bond interest is subject to state and local taxation, most investors won’t pay any taxes on municipal bond interest. As long as the investor is a resident of the state they purchase the bond from, they receive tax-free interest. A California municipal bond pays tax-free interest to any investor with residency in California. However, if a resident of Colorado purchases a municipal bond from California, the investor may be subject to state and local taxation. This depends on the state and locality - some states and cities have income taxes, while some do not. Bottom line - state residents do not pay interest taxes on municipal bonds from their state.

An exception to the residence tax rule exists with US territory bonds, which are also considered municipal bonds. The US territories are:

• American Samoa
• Guam
• The Northern Mariana Islands
• Puerto Rico
• The US Virgin Islands

Regardless of residence, these bonds are always tax-free to the investor. For example, residents of Alaska that purchase US 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 regulation. If a city wants to issue a bond, they are exempt from the SEC’s registration process. When they want to raise capital by selling a security, they just do it without oversight from other parts of the government.

This doesn’t mean the entire municipal market is a free-wheeling, unregulated market. The Municipal Securities Rulemaking Board (MSRB) creates rules and regulations that apply to financial professionals and market participants that work with municipal securities. As it says in their name, the MSRB makes rules. However, they do not have any enforcement power. Other organizations enforce their rules:

Enforces MSRB rules for securities firms

• Securities and Exchange Commission (SEC)
• Financial Industry Regulatory Authority (FINRA)

Enforces MSRB rules for banks

• The Federal Reserve Board
• Office of Comptroller of the Currency
• Federal Deposit Insurance Corporation (FDIC)

We’ll learn more about the important regulators in finance in a future section, but the MSRB is known as a self-regulatory organization (SRO). SROs are non-governmental organizations given power by the government to regulate the financial industry in some way. In particular, the MSRB is given the power to write rules that apply to the municipal securities market and its participants (firms, registered representatives, and traders). FINRA is also an SRO, but FINRA creates rules and enforces them as well.

Throughout this chapter, you’ll come across various rules and regulations relating to municipal securities. These are all based on MSRB rules, which are collectively enforced by SEC and FINRA (for non-banking activities). It’s important to remember these rules do not apply to issuers (the municipalities).

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
• Revenue bonds

General obligation bonds

General obligation (G.O.) bonds are a common type of municipal bond. They support important projects for the city, state, or local area that don’t create revenue. G.O. bonds fund non-self-supporting projects, which include schools, roads, parks, and government buildings. A non-self-supporting project does not make the required revenue to pay for itself.

When a G.O. bond is issued, the municipal government borrows from investors and pays them back over time. Because the bonds can’t be paid off with revenue obtained from the project, the municipality must use taxes to repay their borrowed funds. Specifically, G.O. bonds are paid off with property taxes.

Every year, property owners receive a tax bill from their local government based on how much and what type of property they own. Property taxes, also known as ad valorem taxes, are used to support many things, including school districts, police departments, park maintenance, and city libraries. If a municipality wants to fund a new non-self-supporting project, they raise money through a G.O. bond issuance, pay for the project, and use property taxes to pay back the borrowed funds over time.

G.O. bonds are typically not backed by a specific form of collateral. Instead, they are backed by the full faith, credit, and taxing power of the municipality. Normally, full faith and credit bonds are not as safe as secured bonds, but the taxing power of municipalities is a significant factor. If the state or local government is short of funds necessary to pay off a G.O. bond, they can raise property taxes with voter approval.

Raising taxes can’t always be a fix for a lack of money, though. Many other components, like population growth, economic diversity, and municipal obligations can affect a municipal issuer’s ability to pay off its G.O. bonds. For example, the city of Detroit filed for bankruptcy in 2013, which is still the largest municipal bankruptcy filing in US history. Contributing factors included a declining population, a single dominant industry (auto industry), and significant pension obligations.

When a municipality’s population declines, the local government loses taxpayers. This is why local politicians encourage people and businesses to move to their city. The more people that live in the city, the more taxes the government can assess.

A single, dominant industry within a municipality can be a recipe for disaster. In Detroit, the entire city grew around the automobile industry. When the industry took off, it created a booming city full of opportunities. Workers knew their jobs were stable, made good wages, and were able to live comfortably.

Fast forward to the Great Recession of 2008, and things were different. The economy experienced the largest financial collapse since the Great Depression in the 1920s and 1930s. When the economy is rough, people generally avoid buying durable goods like automobiles.

Auto sales plunged in 2008 and 2009, which created big problems for Detroit. With the entire city built around the industry, there were numerous business closings and layoffs that affected significant portions of the population. These problems contributed to a dwindling tax base over the next several years as many people left Detroit to seek better opportunities outside the city.

Municipalities also face challenges when they have significant payout obligations, like pensions. Pensions are retirement plans which are generally only offered by government entities today. If your job provided a retirement pension, you would be paid an ongoing benefit until death (after retirement). Most employers require at least 20 years of service to be eligible for a pension. When the pension requirements are met, employers typically match their worker’s average earnings at a specific percentage (for example, paying 80% of the worker’s highest year of earnings) throughout their retirement (until death).

Pensions are great for workers as they provide retirement income for life, but they are burdens for employers. Organizations offering pensions know they are on the hook for making a lifetime of payments, regardless of their financial situation. Even if a municipality is experiencing significant financial problems, payment still must be made to pension retirees. When Detroit was financially challenged between the late 2000s / early 2010s, pension payouts strained them further.

In summary, G.O. bonds provide funding to state and local governments for all of the important projects that don’t make their own revenue. The success of a G.O. bond hinges on the municipality’s ability to pay back borrowed funds, which are collected through property taxes. For example, the more diverse the municipality’s economy and the larger the population, the higher quality of the G.O. bond. Economic diversity, which results in many different industries being prominent in the city or state, helps avoid issues that Detroit faced in the late 2000s and early 2010s. A larger population means more people pay property taxes. On the other hand, municipal obligations like pensions may hinder their ability to make required payments.

Revenue bonds

You probably guessed it, but municipal revenue bonds support projects that make revenue. If your city operates anything that makes them money, it was most likely built with funds raised by a revenue bond issue.

Toll roads, airports, stadiums, city zoos, convention centers, and water treatment plants are all examples of ventures supported by revenue bonds. Each is a part of a city’s fabric, but they also obtain revenue from their operations.

If a municipality wants to fund a profitable venture with a revenue bond, it first must ensure its money-making potential. Assume your city wants to build an aquarium, which they hope people will visit and pay to get into. The aquarium will cost millions of dollars and taxpayer money won’t be available for it. To determine the earning potential for the venture, municipalities hire independent consultants to prepare feasibility studies. These are reports created by independent consultants to help the municipality determine if the project or facility will be profitable.

If the feasibility study forecasts a profitable aquarium, the city will begin planning its construction. A self-supporting revenue bond will be issued to the public, and the capital (money) raised will be used to build it. Revenues earned from the aquarium will be used to pay off the bond over time. Most revenue bonds are considered self-supporting because they do not rely on taxes to pay back borrowed funds.

Revenue bonds are not paid off with taxpayer funds, so they do not require voter approval to be issued. For the same reason, revenue bonds are not subject to debt limits either.