Municipal Bond (Definition, Example) | Are Municipal Bond Tax Free?

What is Municipal Bond?

Municipal Bond is a debt security which is issued by the national, state or a local authority to finance the capital outlay 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 risk. 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 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 which 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 of such methods is known as 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:

#1 – Revenue Bonds

These types of bond get its funds from a specific project such as road, toll, etc. This particular source generates income which is used solely for payments of a revenue bond.

#2 – General Bond Obligation (GBO)

The income and principal repayment are done 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 done directly as the return on other investment options is taxable. For comparison, tax-equivalent yield is computed. The formula is:

R_Te = R_Tf / (1-T)

where

R_Te = Tax equivalent return on Muni Bond
R_Tf= 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 which is offering a rate of 5.50%. If he currently falls in a tax bracket of 30%, can you please suggest him which option suits them best? Whether the decision changes if the investor is in the tax bracket of 10%?

Solutions

Here,

R_Tf= 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 investment in the muni bond is a better option.

Where the investor is in the tax bracket of 10%-

Here,

R_Tf= 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 investment in a corporate bond 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 risk

Disadvantages

Capital gains on the sale of muni bonds are taxable
These values are affected by interest rate risk
The real loss of buying power if compare 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 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 2/3^rd of municipal securities are held by the individuals directly or by way of mutual funds. As per Moodys, only 0.18% investment-grade muni bond issuances defaulted as compared to investment-grade corporate bonds where the default rate was 1.74% till 2016. Nearly 2/3^rd of US infrastructure projects are financed by issuing such bonds.

Conclusion

These are issued mainly for financing public expenditure which is capital in nature. Since, the repayment is done from the tax, toll income, and other such collections which 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.