Municipal bonds are issued by states, cities, counties, and political subdivisions. If you 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
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
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
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:
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 its name, the MSRB makes rules. However, they do not have any enforcement power. Other organizations enforce their rules:
Enforces MSRB rules for securities firms
Enforces MSRB rules for banks
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.
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