What is Municipal Bond?
Municipal Bond is a debt security that is issued by the national, state, or local authority to finance the 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 projects related to the development and maintenance of infrastructures like roads, railway, schools, hospitals, and airports. It is also known as Muni Bonds or Notes or Certificates of Participation.
Is Municipal Bond Tax-Free?
Tax relief is offered on the income earned on the municipal bond, and therefore they are tax-free. Further, the bond is issued by the government, which has a nominal counter-party 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. These are the reasons why the interest offered on the municipal bonds is less than the fixed income securities of the same features.
- There are various counterparties to these bonds. These are issued by state or city or government organizations for primarily funding the capital expenditure. Such an organization is denoted as the “Issuer.” The person or entity who is investing in the municipal bonds is known as the “Investor.” The principal and interest are liable to be paid by the issuer or the underlying borrower, who is known as the “Obligor.”
- The important terms & conditions, including the return, mode of payment, usage of funds, the fashion of repayment, etc. are mentioned in the disclosure document, which is known as “Official Statement.”
- Municipal bond market indices are based on the estimated bond prices. But it is better to base the indices on the prices of actual transactions. One such methods is known as the Repeat Sales Method, which assumes a little or no change in bond characteristics and assumes that the movement in prices is due to a change in market conditions.
- The rules and policies regarding such bond issuances, secondary market transactions, and investment firms are made by the regulating body, which is called as MSRB, The Municipal Securities Rulemaking Board. It is a self-regulatory body created in 1975 by the U.S. Congress, which discharge its functions with the help of 4 standing committees. In 1980, MSRB played an instrumental role in transitioning from paper-based municipal bonds to the electronic version.
Municipal Bond Types
Two types of municipal bonds are usually issued in the market:
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For eg:
Source: Municipal Bond (wallstreetmojo.com)
#1 – Revenue Bonds
These types of bonds get their funds from a specific project such as road, toll, etc. This particular source generates income, which is used solely for payments of a 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.
#2 – General Bond Obligation (GBO)
The income and principal repayment are made from the general funds. No particular source is assigned in general. In some cases, the bonds are backed by property taxes, whether with limited or unlimited-tax GBO. It is often an investment-grade bond. The holders have a right to ask the government to levy the tax to pay the obligations on the bonds. These bonds are issued under the backing of ‘full faith & credit’ of the municipality or government organization.
Municipal Bond Return Formula
The comparison of return on the municipal bond cannot be made directly as the return on other investment options is taxable. For comparison, a tax-equivalent yield is computed. The formula is:
where
- RTe = Tax equivalent return on Muni Bond
- RTf = Tax-free return on Municipal Bond
- T = Tax Rate applicable as per the income tax bracket
Municipal Bond Example
An investor wants to invest the excess funds lying. He wants to choose one of the investment options where the first one is a municipal bond, which is yielding him 4%, while the second one is a corporate bond that is offering a rate of 5.50%. If he currently falls in a tax bracket of 30%, can you please suggest to him which option suits them best? Whether the decision changes if the investor is in the tax bracket of 10%?
Solutions
Here,
- RTf = 4%
- T = 30% or 0.3
By formula,
Here, the tax-equivalent yield of the municipal bond (5.71%) is more than the return on a taxable bond (5.50%). Hence the investment in the muni bond is a better option.
Where the investor is in the tax bracket of 10%-
Here,
- RTf = 4%
- T = 10% or 0.1
By formula,
Here, the tax-equivalent yield of the municipal bond (4.44%) fell short of the return on a taxable bond (5.50%). Hence the investment in a corporate bondCorporate 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 is suggested.
Advantages
- Return on Municipal Bonds are Tax-Free
- Return is comparatively less volatile
- The secondary market for the Muni bond is highly liquid
- Comparatively higher net of the tax return for people in higher tax brackets
- Lower credit or 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
Disadvantages
- Capital gains on the sale of muni bonds are taxable
- These values are affected by 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
- The real loss of buying power if compared to the nominal returns of municipal bonds
- Municipal bond tax-equivalent yield is comparatively lesser for people in the lower tax bracket
Latest Trends
A lot of information on municipal bonds is available online. Users can access www.emma.msrb.org for accessing the information on muni bond issuance currently trading, their prices, issue, delinquent interest earnings & principal, changes in ratings, changes in taxability, which are collectively called ‘material notice events.’ EMMA stands for ‘Electronic Municipal Market Access.’
As per Municipal Securities Rulemaking Board (MSRB), the municipal bond market is a $3.8 trillion capital market with approximately 1 million outstanding municipal securities. This market faces 40,000 daily trades with a daily turnover of around $11.6 billion. It is observed that almost 2/3rd of municipal securities are held by the individuals directly or by way of mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more. As per Moodys, only 0.18% of investment-grade muni bond issuances defaulted as compared to investment-grade corporate bonds where the default rate was 1.74% till 2016. Nearly 2/3rd of US infrastructure projects are financed by issuing such bonds.
Conclusion
These are issued mainly for financing public expenditure, which is capital in natureExpenditure, Which Is Capital In NatureCapex 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. Since the repayment is made from the tax, toll income, and other such collections that are binding in nature, the chances of default are quite minimal. An investment in municipal bonds suits more to a person who falls in a higher tax bracket. Due to the conversion of the municipal bond market into an electronic version, the investment has become effortless.
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This has been a guide to What is Municipal Bond, and it’s Definition. Here we discuss the formula to calculate the municipal bond examples along with types, advantages, and disadvantages. You can learn more about fixed income from the following articles –
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