Municipal bonds

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Municipal bonds are bonds issued by states and local governments.

Types of municipal bonds

  • General Obligation Bonds are municipal bonds secured by the taxing and borrowing power of the municipality issuing it. [1]
  • Revenue Bonds are municipal bonds supported by the revenue from a specific project, such as a toll bridge, highway, or local stadium.[2]
  • Assessment Bonds are special types of municipal bonds used to fund a development project. Interest owed to lenders is paid by taxes levied on the community benefiting from the particular bond-funded project. [3]

Taxation

Interest

Interest from municipal bonds is generally exempt from federal income tax and the issuing state's income tax. However, there are a few exceptions.

  • Interest from some municipal bonds is subject to Alternative Minimum Tax (AMT) although whether you actually have to pay AMT depends on your individual circumstances. Such bonds are commonly referred to as AMT bonds.
  • Some states charge income tax on interest from their own municipal bonds.

Capital gains/losses

Capital gains and losses are subject to taxation. One notable point is the treatment of short-term capital losses. If you have short-term capital loss due to tax-exempt interest from a mutual fund held less than 6 months or less, you cannot claim the loss. You can still claim a part of the loss due to market movements, such a rising interest rate. See Publication 564 (2007), Mutual Fund Distributions and Short-Term Capital Losses for more details.

Risks

Call risk

Many bonds are issued with provisions which allow the issuer to repay the bond before the bond reaches maturity. This is termed "calling" the bond. Since issuers call bonds when interest rates fall and the the cost of financing the debt is cheaper in the new lower rate environment, a called bond is disadvantageous to the investor, who now must reinvest the returned capital at lower interest rates. An additional risk with a bond with a call feature is the tendency of the bond to have shifting durations as the likelihood of a call rises and falls with the fluctuation of market interest rates. The bond will sometimes be priced to the call date (when interest rates are falling); at other times to the maturity date (when interest rates are rising).[4] Bonds with a call feature usually pay a higher interest rate than non-callable bonds as partial compensation for the increased risk.

Credit risk

Credit risk is generally much less than that for corporate bonds. Nonetheless, it exists.(Refer to Moody’s US Municipal Bond Rating Scale for data on defaults). Some municipal bonds are insured by private insurance companies. (AFGI Investors' Frequently Asked Questions}

Some investors seek to mitigate the credit risk by diversifying their municipal bonds beyond the state of residence. The caveat is that they may have to pay state income tax on the interest from out-of-state municipal bonds.

Liquidity risk

Municipal bonds are generally illiquid, especially at the retail level. To mitigate the risk, you may consider holding them to maturity or holding them through a low-cost mutual fund, which can trade on the wholesale market.

Role in a portfolio

  • If you have filled up your tax-advantaged accounts with tax-inefficient assets (taxable bonds, REITs, commodities, etc), and you still need bonds to meet your desired stock/bond asset allocation, you might consider placing municipal bonds (or a mutual fund thereof) in your taxable account.
  • If you are in high tax brackets, and you are saving for short-term cash needs (such as car, home down payment, etc), then you might consider short-term municipal bonds or tax-exempt money market funds. (Note that Vanguard's tax-exempt money market funds contain AMT bonds. Fidelity offers some AMT-free tax-exempt money market funds as well as those with AMT bonds in them.)

Taxable equivalent yield

Taxable equivalent yield of a municipal bond is one that a taxable bond would have to pay to deliver the same amount of income as the municipal bond. The taxable equivalent yield depends on the investor's tax brackets. The following calculators allow you to calculate the taxable equivalent yield.

It's important to calculate the taxable equivalent yield before purchasing municipal bonds because taxable bonds with comparable credit ratings may have greater yields.

References

  1. Investor Words
  2. Investopedia
  3. Investopedia
  4. This tendency is known as negative convexity. See Bonds: Advanced Topics

Links

Academic Papers

  • Downing, Chris T. and Zhang, Frank Xiaoling, "Trading Activity and Price Volatility in the Municipal Bond Market". FEDS Working Paper No. 2002-39. Available at SSRN: http://ssrn.com/abstract=333620
  • Harris, Lawrence and Piwowar, Michael S., "Municipal Bond Liquidity"(February 13, 2004). AFA 2005 Philadelphia Meetings. Available at SSRN: http://ssrn.com/abstract=503062
  • Singh, Rajdeep and Nanda, Vikram K.,Bond Insurance: "What is Special about Munis?". Available at SSRN: http://ssrn.com/abstract=171412 or DOI: 10.2139/ssrn.10.2139/ssrn.171412
  • Wu, Chunchi, Wang, Junbo and Zhang, Frank Xiaoling, "Liquidity, Default, Taxes and Yields on Municipal Bonds"(March 14, 2006). FEDS Working Paper No. 2005-35. Available at SSRN: http://ssrn.com/abstract=687500

Further Reading