Municipal Bond

Municipal Bond Definition

Municipal Bond is a debt instrument issued by the government entity to fund the capital spending on public works like constructing highways, schools, and hospitals. It provides a tax-exempt revenue stream for capital preservation.

The municipal (Muni) bond investors loan money to the bond issuer in return for periodic interest payments throughout a fixed term, generally semi-annually. When the bond matures, the issuer refunds the principal amount to the investor. Moreover, the interest on the Muni bond is usually exempt from federal income tax.

• A municipal bond is a fixed-income debt obligation issued by the municipality, county, or state to finance the capital disbursement on public projects like building bridges or hospitals.
• The Muni bond investors lend finances to the issuer in exchange for predetermined interest earnings over a set period. Upon maturity, they receive the entire original investment.
• It is typically untaxed at the federal level and has two types: general obligation bonds and revenue bonds.
• The risks involved in Muni bond investment are credit risks, call risks, inflation risks, liquidity risks, and interest rate risks.

Municipal Bond Explained

Municipal bond investors might be more cautious than stock investors and mostly relish a stable series of income amounts with lesser credit risk. They certainly emphasize wealth conservation more than wealth maximization through capital outlay on public works.

The maturity period of the Muni bond ranges from 1-3 years (short-term bonds) to over ten years (long-term bonds). Furthermore, it is impractical to directly compare the rate of return on municipal bond funds since the revenue on other investment alternatives is taxable. Thus, the tax-equivalent yield is calculated for the comparison.

Here lies the formula:

RTe = RTf / (1-T)

Where,

• RTe = Tax equivalent return on the Municipal Bond
• RTf = Tax-free return on municipal bond investing
• T = Tax Rate, applicable according to the tax bracket

Individual investors have two options for Muni bond investment to be used for capital expenditure on public works. They may either directly buy the bonds from the entity issuing the instrument or utilize pooled investment tactics like mutual funds for more disclosure of several Muni bond issues.

For more information on municipal bonds, interested individuals can also visit the EMMA website. Short for 'Electronic Municipal Market Access', it provides details on current muni bond issuance, prices, issues, etc.

Municipal Bond Types

Now, here are the two most general types of Muni bonds:

1. General Obligation Bonds

Counties, states, or cities issue these general obligation bonds. Moreover, they are not secured by assets but are advocated by the “full faith and credit” of the bond-issuer, which may tax residents for payment to bondholders.

2. Revenue Bonds

The revenue bond is backed by earnings obtained from a particular project source, including lease payments or highway tolls. A few of these are “non-recourse” bonds, denoting that the bondholders can’t claim the underlying income source if cash flows are drained.

Examples

Now, let’s go through a few examples.

Example#1

Suppose that Lucy and Nash have two alternatives for investment in the excess funds. While the first option is to invest in municipal bond funds with a 4% rate of return, the second one is corporate bonds with a 5.50% return rate. Both Lucy and Nash have a 30% and 10% tax bracket, respectively.

• So, for Lucy:

RTf = 4%

T = 30% or 0.3

Going by the formula,

RTe = RTf / (1-T)

In this case, the Muni bond’s tax-equivalent yield (5.71%) is more than the return on a taxable bond (5.50%). Therefore, Lucy must invest in the Muni bond.

• Now, for Nash:

RTf  = 4%

T = 10% or 0.1

Going by the formula,

RTe = RTf / (1-T)

Now, the tax-equivalent yield of the Muni bond (4.44%) is less than the return on a taxable bond (5.50%). Thus, corporate bond investing is a profitable option for Nash.

Example #2

As per Refinitiv Lipper data, investors have channeled $96.8 billion in US Municipal exchange-traded and mutual funds in 2021.

Some investors are bracing themselves for the federal reserve’s determined interest rate surges causing possible price reductions. However, on the other hand, advisors believe that higher interest rates will benefit a typical Muni bond investor.

As per Ian Weinberg (CFP and CEO of Family Wealth and Pension Management), it offers a counterbalance to the investors concerning prospective inflationary surges in tax rates.

Risks In Municipal Bond

To clarify, let’s check out the risks involved in municipal bond investing:

Credit Risk

It infers that the bond issuers may be incapable of complete principal and interest payment (also called default risk) because of financial issues. Several bonds also come with credit ratings to guess their corresponding credit risk compared to other bonds. Nonetheless, high ratings do not signify defaulting uncertainty.

Inflation Risk

The increasing shift in prices declines the purchasing power, thus resulting in surged interest rates. This certainly endangers investors from gaining a predetermined interest rate as the market worth for current bonds reduces.

Call Risk

Call Risk demonstrates the bond issuer's repayment capability before maturity, mostly when interest rates diminish. Please note that various Muni bonds are “callable.” So, investors who prefer to hold the bond till maturity must examine its call provisions before the purchase.

Interest Rate Risk

If held till maturity, Muni bond investors get back its fixed face value amount and the set interest payment. Moreover, the municipal bond rates soar as interest rates decline and vice-versa. It ensures that the bond’s market value might be more or less than its face value.

If the currently lower US interest rates move higher, the investors with low fixed-rate bonds must not sell them before the maturity date. Or else, they may encounter financial loss due to its lesser market value.

Liquidity Risk

It implies the incapability of investors to spot an active municipal bond market. It hinders them from trading whenever preferred and receiving a specific rate. Numerous investors purchase these bonds not to trade but to hold them. Hence, the market for a particular bond might not be extremely liquid, and its quoted rates may vary.

Is Municipal Bond Tax-free?

As aforementioned, income earned by the municipal bond market is not liable to federal tax. If the investor resides where the Muni bond is issued, it can also stay untaxed at the local and state levels.

Please note that Muni bonds are liable to the interest rate risk. If the interest rates surge beyond the municipal bond rates, the bond value lessens in the secondary market. Typically, the interest rate on these bonds is less than the taxable fixed-income instruments such as corporate bonds with the same credit qualities and maturities.

When compared with nominal returns of Muni bonds, it registers the actual loss of buying power.

Frequently Asked Questions (FAQs)

Recommended Articles

This has been a guide to Municipal Bond and its Definition. Here we describe the municipal bond funds, their types, investing risks, and examples. You can learn more about fixed income from the following articles –

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