Municipal bonds are issued by state, city, county, and other local government entities (often called political subdivisions). If you’ve ever wondered how your town pays for major projects, municipal bonds are a big part of the answer. Local roads, schools, and parks are often built with money the municipality borrows by issuing bonds. While national politics gets a lot of attention, state and local decisions often have the most direct impact on day-to-day life.
You’ll see three main forms of municipal debt securities later in this unit:
General obligation bonds are issued to finance public, non-self-supporting projects. In other words, they fund municipal services that benefit the public but don’t generate their own revenue. Examples include public school systems, parks, and non-toll roads.
Revenue bonds are issued to finance self-supporting projects - projects expected to generate revenue. Examples include municipal-owned toll roads, airports, and stadiums.
Short-term notes are issued to finance needs that can be repaid over a short period. You’ll learn about anticipation notes, which help municipalities access funds before they receive taxes or other expected revenue. You’ll also cover variable rate demand notes, which give investors a distinctive way to provide short-term funding to a municipality.
Understanding how bond interest is taxed matters throughout this unit. One of the most important features of municipal securities is their tax treatment. Even though you haven’t covered U.S. government debt yet, these are the general rules to know:
Corporate bond interest
Municipal bond interest
US government bond interest
Corporate bond interest is fully taxable to investors. That’s one reason corporate bonds often offer higher yields than other issuer types: the issuer generally needs to pay enough interest to provide an acceptable after-tax return.
Municipal bond interest is typically exempt from federal tax, but it can be subject to state and local taxes. If an investor lives in the state (or locality) where the bond is issued, the interest is often exempt from those state and local taxes as well. If the bondholder lives outside the issuing state (or locality), the interest is generally subject to that state and local taxation.
An exception to the residence rule applies to US territory bonds, which are also municipal bonds. The US territories are:
Regardless of where the investor lives, interest on these bonds is tax-free. For example, a resident of Alaska who buys U.S. Virgin Islands bonds receives interest that is entirely tax-free.
You’ll cover U.S. government bonds in more detail later. For now, remember that interest on U.S. government securities is exempt from state and local taxes but is subject to federal tax. A common pattern shows up here: governments generally don’t tax the securities issued by other governments. That’s why U.S. government securities are exempt from municipal taxation, and municipal securities are exempt from federal taxation.
There are exceptions to these general rules. You’ll see some of them in later sections.
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