Municipal Bonds: The Basics, Or How I Learned To Stop Worrying And Love The Tingle Of Tax- Free Income.

by: Josh Cantrell

Summary

Municipal bonds can provide tax-free income, which can add tax-strategy flexibility to an investment portfolio.

Municipal bonds give a local governmental entity the ability to monetize revenue as needed to facilitate public planning and public works projects.

For the average investor, a municipal bond fund is probably a better choice than owning shares of a specific municipal bond.

Photo: flickr.com

I usually write about individual companies that I like for investment purposes rather than on bonds or broader topics such as portfolio management. However, as a former municipal attorney I have some experience with how municipal bonds are structured from the "administrative" side and thought it would be useful to write a brief introductory article for those who might find some value in incorporating these types of assets into their investment strategies.

This is not intended as a deep dive into the nuances of municipal bonds nor is it in any way remotely exhaustive. Rather, it is a simple introduction to the basics of what municipal bonds are, some of the reasons an individual investor might consider them and references to a couple of additional sources of information so that interested investors can investigate further.

Why would an investor want to own municipal bonds?

For one thing, municipal bonds tend to be relatively (though not absolutely) safe. U.S. Treasury bonds are still safer than municipal bonds, but don't generally provide the same level of return.

From an investor standpoint, the main advantage to owning municipal bonds is the tax-free nature of the income they generate. (NOTE: capital appreciation of bond value is generally NOT tax-free… just the income they generate). While a 3% rate of return may not sound like much, consider how much better it seems if you are in a 30% tax bracket… you would need to generate a 4.3% taxable rate of return to match the net value of an untaxed 3% rate.

Photo: investmentadvisortips.com

Tax-free income can also provide a big benefit in minimizing your marginal income tax rate while maintaining real cash flow and can also give you additional flexibility for general tax strategizing. Unfortunately a comprehensive guide to maximizing tax benefits via a mixture of sources of income is beyond the scope of this article, but suffice it to say it can be advantageous to maintain assets with different tax treatment within your overall portfolio.

So, what is a municipal bond?

In simplest terms, a municipal bond is essentially a loan to a (non-Federal) governmental entity that is secured by public monies, such as tax revenue. As with other types of bonds, municipal bonds have a face value and pay a set rate of interest (known as the "coupon rate") over a specified period of years (the "maturity date"), after which time the bonds are redeemed for face value.

A basic scenario would go like this: Due to an increase in population, River City needs to expand and improve its roads. After multiple planning sessions held in open meetings, the city has determined it will need $4 million to implement its Roadway Improvement Program (RIP). Last year the citizens of River City authorized a ¼ cent-per-gallon tax on gas purchased within the city limits to fund future road projects. This gas tax has generated $300,000 in revenue for the city over the initial one-year period and, for the purposes of this example, is expected to remain steady at this level for 20 years.

While River City now has an authorized source of income to fund the RIP, it doesn't yet have the $4,000,000 it needs to undertake and complete the program. In fact, if the gas tax revenue stays steady at $300,000 per year, it will be 13.33 years before the city will have enough to commence the project. In the meantime, the existing roads in the city will continue to deteriorate and a significant amount of both commercial and residential development will bypass the area for the nearby town of Agrestic, which decides to take advantage of River City's inaction by building a beautiful master-planned system of roads. Slowly, quality of life begins to deteriorate in River City, which leads to a net loss of commerce and population, which leads to a decrease in the tax base, which leads to further deterioration of city services and facilities, etc. , etc… Agrestic wins. River City turns into BarterTown.

Instead of waiting to accumulate enough funding, River City can issue a bond for the amount needed for the RIP and pledge the gas tax revenue to the repayment of this bond on terms that investors would find favorable enough to purchase. The advantage for the municipality is that, instead of waiting for tax revenues to accumulate to the point where the entity has enough cash to build a road or hospital, it will receive a lump sum payment that it will repay through these revenues. This allows the municipality to move forward with important public works projects as the need arises.

Based on these numbers, River City (working through a financial intermediary that packages and sells the bonds on the open market for a fee) issues a bond for $4,000,000 (in $5000 face value blocks) with a coupon (interest) rate of 2.5% and a maturity of 20 years. So each year for 20 years River City must pay holders of this bond 2.5% of $4,000,000, or $100,000 (for a total of $2,000,000 in interest payments). At the end of the 20 years, River City must make a lump-sum payment of $4,000,000 to redeem the bonds at face value, for a total outlay of $6,000,000 over the 20-year period ($2,000,000 in cumulative interest payments plus the $4,000,000 redemption payment). The ¼ cent-per-gallon gas tax has continued to generate $300,000 per year for a 20-year total of $6,000,000.

Photo: allstarcharts.com

In fact, because River City managed to get its new roads built relatively quickly, a couple of major employers decided to locate within the city limits, which in turn attracted new home developers, which in turn increased both the population and property values of River City, which increased tax revenues that allowed the city to issue another bond to build a beautiful new wastewater treatment facility. Agrestic never gets off the ground. River City wins.

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River City after successful bond election. Probably.

How is a municipal bond different from a corporate bond?

Unlike corporations, local governments need to have statutory authorization to pledge public revenue for the issuance and payment of bonds. The local governmental entity is also generally limited to spending the bond money for "public purposes," though the range of specific restrictions can vary from bond to bond depending on the enabling legislation. They also must often adhere to certain debt limits (yes, I hear you chuckling, but it's actually somewhat true at the local level…) and fulfill certain public meeting and on-the-record voting requirements which will vary from jurisdiction to jurisdiction.

All things being equal, municipal bonds are safer than corporate bonds, since municipal bonds are guaranteed by the revenues of a public entity that is not engaged in a competitive business endeavor. Which is not to suggest that municipal bonds are immune from default -- any activity involving money is potentially vulnerable to the slings and arrows of outrageous fortune -- but there is a much larger degree of transparency and oversight by publicly accountable entities that does tend to add a layer of safety to municipal bonds. (Yeah, I heard you snicker again…you in the back. Stop that.)

Finally, as previously mentioned, in most cases the interest payments bondholders receive from municipal bonds are tax-free. Corporate bond interest payments are not.

Photo:aaii.com

What are the different types of municipal bonds?

From an investor perspective it's relevant to know whether you are investing in a "General Obligation" bond or a "Revenue" bond.

A "General Obligation" bond is a bond that is issued by a local governmental entity but is not tied to any specific asset or source of revenue. Instead these are bonds that are backed by the "full faith and credit" of the governmental entity, which means basically that in purchasing these bonds you are placing some trust in that entity's ability to repay the loan in a general sense. When considering purchasing General Obligation bonds an investor would be most interested in the governmental entity's credit rating and overall economic health. Although U.S. Treasury bonds are not municipal bonds, they are an example of a "full faith and credit" bond.

A "Revenue" bond, on the other hand, is a bond that, like our River City example above, is backed by a specific asset or source of revenue. When contemplating revenue bonds, consider the strength and viability of the revenue source over the lifetime of the bond. In our example, we decided that we expected the ¼ cent-per-gallon gasoline tax to generate sufficient revenue over the lifetime of the bond to ensure payment of both interest and face value redemption on the maturity date.

Should an investor own an individual bond or go with a bond fund?

From a technical standpoint an individual investor could own units or shares of an individual municipal bond, if they so choose. All of the information you would need to conduct background and research on a given bond will be publicly available and there are platforms that are more than happy to facilitate a purchase or sale of almost any type of security.

Photo: Scriptophily.net

Where nosy fellas put their money, kitty cat…

Of course, investing in any individual product or security leaves the investor exposed to "single asset risk," which is why most pros advise a well-diversified portfolio of assets in the first place. So the best bet for an individual investor is probably going to be to look for a municipal bond fund that meets the individual investor's particular investment goals and income needs.

There are as many different types of municipal bond funds as there are any other types of managed asset products. Some have a more conservative approach, which generally entails funds that consist of assets with high credit ratings and little risk of default, while others have a more aggressive asset mix profile. Of course, as with any investment, higher returns generally entail accepting higher risk. The key, as always, is to know what it is you are buying and to make sure you are comfortable before parting with your hard-earned money.

Where can an investor get information about municipal bonds?

A simple Google search for "municipal bonds" will turn up an almost overwhelming list of potential information sources for research and investing purposes. Below are links to three of these sources that I have found to be helpful, though your individual mileage may vary.

EMMA: Electronic Municipal Market Access

Website maintained by the Municipal Securities Rulemaking Board (MSRB). EMMA is the official repository for information on virtually all municipal bonds, providing free access to official disclosures, trade data and other information about the municipal securities market.

municipalbonds.com

Website providing comprehensive information about municipal bonds and the municipal bond market, including real time buy/sell market activity, bond screens, free newsletters, educational tools, links to additional municipal bond resources, and tools for buying and selling municipal bonds.

Municipal Bond Information Service

Municipal Bond Information Services is a group of eleven firms, including ten that specialize in municipal inter-dealer brokerage, that have assembled to create a consortium for the purpose of aggregating the market data generated by businesses of these entities.

NOTE: the author is not affiliated with any entity referenced in this article, nor has he received any compensation or solicitation from any third party for this or any other article or work. Reference to such third parties does not constitute an endorsement or recommendation to utilize these particular services or information resources. References are provided only as a helpful starting point for an individual investor to conduct their own research to their own satisfaction before making any investment decisions and the author explicitly disclaims any liability or responsibility for any investment decisions made by any investor(s) based on information in this article. Any links provided to third party websites or any names of third parties have been selected at the sole discretion of the author and should not be considered a comprehensive list of such resources.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.