Municipal Bond Primer – Part 1.

This month we take up an area of investments that is of special interest to fixed-income investors – the municipal bond market.

What are they? The term “municipal bond” is somewhat of a misnomer. Municipal bonds certainly include bonds issued by municipalities (i.e. cities, towns and counties), but it also includes bonds issued by individual states and other governmental and quasigovernmental entities. The bonds are issued by these entities to raise money for various projects. Municipal bonds might be issued to raise money to build a hospital for example, or to fund construction of your favorite sports team’s stadium.

Are they widely held investments? Absolutely. According to the Securities Industry and Financial Markets Association, more than $2.6 trillion in municipal bonds was outstanding in 2007, two-thirds of which was held by U.S. households or mutual funds.

How do they work? Municipal bonds, in one sense, are like any other bond. You are loaning money to the issuer in exchange for a set number of fixed, regular interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date and the full amount of your original investment is returned to you.

Where does the money come from to pay you back? In general, municipal bonds are paid back in two ways: (1) through the ability of the issuer to obtain tax receipts; or (2) through income generated by the project the bond is raising money for. The first type is typically referred to as a general obligation bond, the most common of which are issued by State governments who have the power to tax their citizens. The second type is typically referred to as revenue bonds. Revenue bonds are most concerned with the repayment of interest to lenders who believe in financing a given public works project such as, tunnels, parks, and buildings of education. In the case of education or school systems, bonds issued for colleges and universities are from the state level and are generally backed by income or progressive taxes. Bonds, which are issued by towns, cities, and counties, are backed by local property (ad valorem) or regressive taxes and all other sources of revenue to the municipality

What makes municipal bonds special? Many (but not all) municipal bonds have special tax advantages on the interest paid that make them unique as compared to a typical bond. Specifically, an investor in a tax-free municipal bond will ordinarily not have to pay federal income taxes on the interest, or income taxes of the state in which the bond was issued. For individuals in high income tax brackets, that can make municipal bonds particularly attractive as the after-tax yield can deliver better returns than taxable bonds of comparable quality.

How do you determine if the municipal bond pays a better yield? Comparing the coupon rates of municipal bonds to corporate or other taxable bonds is not an apples-to-apples comparison because taxes reduce the net income on taxable bonds. The following simple formula can help you do the necessary calculation: (tax-free rate / 1-federal tax bracket = taxable-equivalent yield). For example, if you were in the 25% federal income-tax bracket and you were offered a corporate bond yielding 7% or a tax-free municipal bond yielding 5%, which would you choose? Using the foregoing formula, your taxable-equivalent yield would equal the tax-free rate (5% in this example) divided by 1 minus 0.25, or 0.75. The answer: 6.67%. In this case, you're better off with the taxable bond. But if you were in the 35% tax bracket, then the municipal bond would give you a tax-equivalent yield of 7.59%, making it more attractive. Next month we will continue our discussion of municipal bonds, including risk factors, individual bonds vs. funds and the creation of a municipal bond ladder.

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