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Municipal Bond

Updated on April 30, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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.

Municipal Bond Definition

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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.

Key Takeaways

  • 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 riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more. They certainly emphasize wealth conservation more than wealth maximizationWealth MaximizationWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits.read more through capital outlayCapital OutlayCapital outlay, or the capital expenditure, refers to the sum of money spent by the company to purchase the capital assets such as plant, machinery, property, equipment or for extending the life of its existing assets to increase production capacity.read more on public works.

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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 yieldTax-equivalent YieldThe tax-equivalent yield means how much yield (pre-tax returns) you would earn if you pay taxes on your tax-free investments. It will help you compare the yield between a tax-free investment and a taxed investment, and you will be able to find out whether the taxed investment is a good deal or not.read more 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 expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more on public works. They may either directly buy the bonds from the entity issuing the instrument or utilize pooled investment tactics like mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more 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:

Municipal Bond Types

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1. General Obligation Bonds

Counties, states, or cities issue these general obligation bondsGeneral Obligation BondsGeneral Obligation Bonds are a type of bond that is supported or guaranteed by agencies like municipalities where repayments are prompt and have very low default rates as municipals are authorized by the government to increase the tax amount that is receivable from the public to pay off the dues and debts associated with the repayments to the investors.read more. 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 bondholdersBondholdersA bondholder is an investor who buys or holds a government or corporate bond.read more.

2. Revenue Bonds

The revenue bondRevenue BondRevenue bonds are bonds issued by municipal corporations where the revenue from income-producing projects such as toll bridge, highway, sewer facilities, airport construction, roads, local stadium are used in repaying the debt obligation (both interest and principal component).read more is backed by earnings obtained from a particular project source, including lease paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more or highway tolls. A few of these are “non-recourse” bonds, denoting that the bondholders can’t claim the underlying income source if cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more 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 bondsCorporate BondsA bondholder is an investor who buys or holds a government or corporate bond.read more 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)

Municipal Bond Example 1

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)

Municipal Bond Example 1-1

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 fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more 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:

Municipal Bond Risk

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Credit Risk

It infers that the bond issuers may be incapable of complete principal and interest payment (also called default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more) 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 RiskCall RiskCall risk is the uncertainty that arises when the investors purchase bonds but perceive that the issuer will redeem this debt instrument before its maturity date. Thus, resulting in the possibility that the investors would have to reinvest the disbursed amount at a much lower rate or in an unfavourable investing market scenario.read more 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 riskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more. If the interest rates surge beyond the municipal bond rates, the bond value lessens in the secondary marketSecondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more. Typically, the interest rate on these bonds is less than the taxable fixed-income instruments such as corporate bondsCorporate BondCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more with the same credit qualities and maturities.

When compared with nominal returns of Muni bonds, it registers the actual loss of buying powerBuying PowerBuying power in trading refers to the funds available in the trading account to trade stocks, cryptocurrencies, options, etc. It includes the money held in the brokerage account and the margin available. A change can greatly affect security prices in the financial market in different forms, such as discount rates.read more.

Frequently Asked Questions (FAQs)

Is Municipal Bond Interest Taxable?

The interest obtained from the municipal bond is normally exempt from the federal tax. As long as the investor lives where the bond is issued, it is also tax-free at the state and local levels. Moreover, the interest rate for these bonds is generally lesser than on taxable securities.

How Does Municipal Bonds Work?

The municipal bond investors lend cash to the bond issuer in return for a fixed quantity of interest payments during a prearranged period. When the period ends, the bond reaches maturity, and the investors collect their full principal amount.

Are Municipal Bonds a Good Investment?

Yes, municipal bonds are a good investment for investors who prefer capital preservation while producing a set tax-free interest amount. In addition, with a low default rate, they attract individuals with a high tax bracket choosing to invest in less risky ventures.
 
Moreover, the Muni bond funds contribute to national development through financing public projects.

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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