Foundations & taxation

Foundations

Municipal bonds are issued by state, city, county, and political subdivision governments. If you have ever wondered how your town funds itself, municipal bonds play a crucial role. Your local roads, schools, and parks were most likely built with money borrowed through a municipal bond. Although many of us pay attention to national politics, what happens at our state and local levels tends to influence our daily routines the most.

We’ll discuss these three distinct forms of municipal debt securities later in this unit:

• General obligation bonds
• Revenue bonds
• Short-term notes

General obligation bonds are issued to finance public non-self supporting projects. In plain English, these securities fund municipal activities that are important to the general public but don’t make revenue. Examples include public school systems, parks, and non-toll roads.

Revenue bonds are issued to finance self-supporting projects. These are related to municipal activities that make money. Examples include municipal-owned toll roads, airports, and stadiums.

Short-term notes are issued to finance activities that can be paid off in a short period. We’ll learn about anticipation notes, which allow municipalities to gain access to funding prior to receiving taxes or other forms of capital. Additionally, we’ll discuss variable rate demand notes, which provide investors with a unique way of supporting their municipality.

Taxation

It’s essential to understand how bond taxation works as we make our way through this unit. One of the most prominent benefits of municipal securities is how they’re taxed. It might feel like we’re jumping ahead a bit (because we haven’t covered US government debt yet), but here are the generalities you need to know:

Corporate bond interest

• Subject to federal, state, and local taxation

Municipal bond interest

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

US government bond interest

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

Corporate bond interest is fully taxable to investors, which is one of the reasons why they maintain the highest yields of the issuer types. A corporate bond must pay enough interest to provide an acceptable after-tax return.

Municipal bond interest is typically tax-free but is technically subject to state and local taxes. If the investor is a resident of the municipality where the bond is being issued, they can avoid state and local taxation. If the bondholder lives outside the municipality, interest is subject to state and local taxes.

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 entirely tax-free.

We have yet to learn about US government bonds, but the interest generated from these securities is exempt from state and local taxes while subject to federal taxes. You may have noticed a theme here - governments don’t tax the securities of other governments. US government securities are exempt from municipal taxation, and municipal securities are exempt from federal taxation.

There are exceptions to the generalities we just discussed. We’ll come across some exceptions in future sections and talk about them in detail.