Municipal bonds are issued by states, cities, counties, and other political subdivisions. They’re one of the main ways local governments borrow money to fund public projects. Many roads, schools, and parks are built (or improved) with money raised 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 can affect local services, infrastructure, and overall quality of life.
Municipal bonds are typically structured like other bonds. Most pay semi-annual 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. Normally, interest received from bonds is taxable. However, 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 relates directly to yields. Because corporate bond interest is taxed at multiple levels, corporate bonds typically offer higher yields than US Government and municipal securities. Risk is also a factor; of the three issuer types, corporate securities generally come with the most risk and the most return potential.
US Government bonds interest
We haven’t covered US Government securities yet, but the key idea is that the interest paid on these securities is taxed by their issuer (the federal government), not by state or local governments. A helpful way to remember this is: 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. Using the same memory aid: governments are the only ones that tax their own securities, so other levels of government (here, the federal government) do not tax municipal bond interest.
Municipal bond interest can be subject to state and local taxation, but many investors still pay no taxes on it. As long as the investor is a resident of the state that issued the bond, the interest is typically tax-free at the state and local level as well. For example, a California municipal bond pays tax-free interest to an investor who is a California resident. However, if a resident of Colorado purchases a municipal bond from California, the investor may be subject to Colorado 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 who 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, it’s exempt from the SEC’s registration process. When a municipality wants to raise capital by selling a security, it can do so without that SEC registration oversight.
This doesn’t mean the entire municipal market is unregulated. The Municipal Securities Rulemaking Board (MSRB) creates rules and regulations that apply to financial professionals and market participants who work with municipal securities. As its name suggests, the MSRB writes rules, but it does not have enforcement power. Other organizations enforce MSRB 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 based on MSRB rules, which are collectively enforced by the SEC and FINRA (for non-banking activities). It’s important to remember that these rules do not apply to issuers (the municipalities).
In this chapter, you’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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