Municipal Securities

Quick Summary of Municipal Securities

A debt security issued by a local government or its agencies or authorities in the United States or its territories.

Municipal securities (or munis) are exempt debt securities issued by state and local governments in the United States and its territories. They include securities issued by agencies or authorities established by those governments. Munis are used to fund items such as infrastructure, schools, libraries, general municipal expenditures or refundings of old debt.

When the United States introduced a federal income tax in 1913, the taxability of interest from municipal securities was challenged based on the constitutional principle of states’ rights. That argument was upheld by the Supreme Court for much of the twentieth century but was finally rejected in a 1983 case. Today, Congress has a right to tax interest income from municipal securities, but it currently chooses not to. Many states also exempt their securities from their own taxes, which makes those securities particularly attractive investments for their own residents. Of course, capital gains from buying or selling munis in the secondary market are fully taxed.

Because of their tax-exempt status, munis have nominal yields below those of corporate bonds or Treasury bonds. To compare a muni’s yield to that of a taxable bond, investors calculate the muni’s tax-equivalent yield using the formula:

tax-equivalent yield = yield / 1 – marginal tax rate

This indicates the yield a taxable bond would have to earn in order to match, after taxes, the yield available on the untaxed muni. Here, marginal tax rate is the tax rate that would apply to one additional dollar of income—if the investor earned one additional dollar, what fraction of that dollar would be lost to federal, state and local income taxes?

Consider an individual investor who pays a marginal tax rate of 34% due to federal, state and local income tax. To compare a muni paying 3% with a taxable corporate bond paying 4%, she would apply formula [1] to obtain a tax-equivalent yield for the muni of 4.55%. Barring other factors, she would likely invest in the muni, since its tax-equivalent yield is superior to the 4% yield on the corporate.

Obviously, tax-equivalent yield depends on the investor’s marginal tax rate. If a property and casualty insurance company is losing money, its marginal tax rate will be 0%. If it compares the same muni paying 3% and corporate paying 4% as in the previous example, it would apply formula [1] to obtain a tax-equivalent yield for the muni of 3%. Barring other factors, the company would probably invest in the corporate.

Munis are not always tax-exempt. Interest on some munis is taxed under the Alternative Minimum Tax (AMT). These are called AMT bonds. If a municipality issues debt to fund a commercial enterprise, such as a shopping mall or sports stadium, the securities are called private activity bonds. To prevent municipalities from engaging in tax arbitrage—issuing debt at tax-free yields while earning a commercial rate or return on the proceeds—interest on private activity bonds is taxable.

To preclude tax arbitrage by securities dealers, any interest paid to finance a position in munis is not deductible as a business expense.

Unlike, the Federal government, which can print money, municipalities cannot. This means that munis entail credit risk. There have been a number of spectacular municipal bankruptcies, so the risk of default is real. Munis are rated, just like corporate bonds, with ratings varying from AAA to D. Some munis are issued with credit enhancement. This may include credit insurance or a bank guarantee, such as a letter of credit.

Long-term munis are called municipal bonds. These typically pay semiannual coupons, but some are zero-coupon or accrued-coupon bonds. These instruments fall into two general categories:

Tax-backed bonds are backed by anticipated tax, penalty or fee revenue. These instruments include general obligation bonds, which are baked by the general tax revenue of the issuer. Some are structured like a securitization of specific revenues, such as sales taxes or fees. There are also a number of structures issued by state or local agencies with some sort of credit enhancement from the state or local government.

Revenue bonds are issued to finance specific revenue-producing projects, such as toll roads, airports, public housing or higher education. Interest and principal are paid out of revenue from the project. The bonds are classified by project type, so you will hear of utility revenue bonds, hospital revenue bonds, transportation revenue bonds, housing revenue bonds, etc.

A third category of municipal bond is refunded bonds.

Refunded bonds (also called pre-refunded bonds) are tax-backed or revenue bonds that the issuer has allocated funds to fully retire. The issuer hasn’t retied the debt yet, either because it is not yet callable or for some other reason. Instead, the issuer has used the allocated funds to buy an offsetting portfolio of bonds, which are placed in escrow or a trust for the benefit of bondholders. The portfolio may hold Treasury securities, agency securities or other high-quality debt. It is structured so its cash flows offset the cash flows due on the refunded bonds. This may be done in anticipation of the bonds being called at the first opportunity, or it may be done assuming that the bonds will be outstanding until maturity. Because they are fully baked by high-quality collateral, refunded bonds tend to have excellent credit quality.

Municipalities issue a number of shorter-term instruments. Most common are municipal notes.

Municipal notes have maturities from three months to three years. Some are issued as discount instruments, but most are coupon-bearing. Typically, notes are issued to address mismatches in the timing of expenditures and offsetting revenues. Tax anticipation notes (TANs) are issued in anticipation of tax revenues. Revenue anticipation notes (RANs) are issued in anticipation of other revenues, such as federal aid. Tax and revenue anticipation notes (TRANs) anticipate either tax and/or other revenue. Grant anticipation notes (GANs) are issued in anticipation of receiving a grant. Bond anticipation notes (BANs) are issued in anticipation of funding from the issuance of municipal bonds. Most notes are issued with credit enhancement, such as a bank letter of credit.

In the past, municipalities used commercial paper to meet much of their short-term funding needs. This had the advantage that municipalities didn’t have to perform a new public offering each time they issued short-term debt. Municipal issuance of commercial paper was severely restricted by the 1986 Tax Reform Act. Since then, municipalities have turned to various floating rate instruments, which were first employed in the 1970s. These have long maturities, so issuers can have infrequent offerings. They also have liquidity features that make them essentially money market instruments.

Variable rate demand obligations (VRDOs), also called variable rate demand notes (VRDNs), are floating rate instruments with terms of as much as 40 years. They pay interest monthly or quarterly based on a floating rate that is reset daily or weekly based on an index of short-term municipal rates. VRDOs are purchased at par. Liquidity is provided with a put feature, which allows the holder to put the security for par plus accrued interest on any interest-rate reset date, usually with one or seven days notice. A remarketing agent—a bank or other entity—serves as a liquidity provider. VRDOs are put back to it rather than the issuer. The remarketing agent tries to resell those VRDOs or, failing that, holds them in its own inventory. VRDOs almost always have credit enhancement—either a letter of credit from the remarketing agent or bond insurance. The issuer generally has an option to convert a VRDO to a fixed-rate instrument. Due to the put feature, tax-exempt money market funds generally can hold VRDOs.

Auction rate securities (ARS) are structured much like VRDOs, but rates are reset and liquidity is provided through a periodic Dutch auction. Investors who wish to acquire an ARS submit bids in that auction. Investors who already hold the ARS have a choice to hold (agree to receive whatever rate is set in the auction), bid (bid in the auction, and relinquish their holding if their bid is not accepted), or sell (redeem their investment at par plus accrued interest, irrespective of auction results). For tax-exempt ARS, auctions are typically held every 7, 28 or 35 days. Interest is usually paid the day after the auction, but less frequent coupon dates are possible. Instruments usually have some form of credit enhancement. Tax-exempt money market funds generally can’t hold ARSs.

While VRDOs and ARSs are unusual, most municipal securities are issued as traditional public offerings. There is an active over-the-counter secondary market for munis. Tax-exempt investors, such as pension plans, don’t generally invest in munis. Most munis are held by property and casualty insurance companies, wealthy individuals who have the highest marginal tax rate, and mutual funds that invest exclusively in munis. Banks or other dealers also hold inventories of municipal securities.

The phrase tax-exempt bond refers to any bond whose interest is not subject to taxation by one or more authorities. In the United States, the term is often used synonymously with municipal bonds. However, non-profit entities like hospitals and museums also issue bonds that are tax exempt. These are structured much like munis, and they are sold to mostly the same investors.

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