Municipal Bonds

Municipal bonds (also called munis) are bonds issued by state or local governments. Most of municipal bonds are exempt from federal and state taxes.

State and local governments issue bonds to raise money for infrastructure development, improvement in public services, short-term liquidity management, etc. Depending on the intended usage of the funds raised and the source of cash flows used to repay those bonds, municipal bonds can be categorized into general obligation bonds, revenue bonds and commercial paper.

General obligation bonds are bonds which are to be repaid out of the combined revenues of the state or local government i.e. state taxes, fees for public services, etc. On the other hand, revenue bonds are bonds whose proceeds are used to finance infrastructure projects such as a bridge, a highway, etc. and they are repaid using the project revenues i.e. toll, etc. only.

Municipal bonds differ from corporate bonds in two ways: (a) they are tax-exempt while corporate bonds are not; and (b) they may have several maturity dates instead of just one while corporate bonds typically have a single maturity date. Municipal bonds also differ from Treasury bonds in that they have a significant default risk while Treasury bonds are considered virtually risk-free.

Tax Equivalent Yield

Since municipal bonds are typically tax-exempt, their yield is lower than yield on taxable bonds of similar terms. For comparison with corporate bonds, it is important to convert the tax-exempt yield of the municipal bonds to their tax-equivalent yield using the following formula:

$$ r_t=\frac{r_e}{(1-t)} $$

Where rt is the tax-equivalent yield, re is the tax-exempt yield and t is the marginal tax rate of the investor.

Advantage and Disadvantages

The most important feature of the municipal bonds which make them a good addition to a fixed income investment portfolio is their federal and state tax exemption. It means that the coupon payments received by the bondholders are not taxable. This advantage is most significant for people who fall in high income tax bracket i.e. who have high marginal tax rate. Another advantage is that due to the compounding effect and tax-exempt nature of the bonds, the future value of your portfolio will grow considerably faster.

Despite their significant advantages, municipal bonds are not a panacea: they typically carry considerably lower yield than corporate bonds and they are not default-free. This is because they are issued by non-sovereign governments.

Example

You are a financial advisor at Plutus Investments. Your two newest clients, Mike and Mary, have marginal tax rates of 15% and 20% respectively. They are considering adding a 10-year tax-exempt municipal bond with a yield of 3% or a comparable corporate bond with a yield of 3.70% to their portfolios. You need to find out which investment is better.

You must find out the tax-equivalent yield of the municipal bond for both clients and then compare it with yield of the taxable corporate bond.

$$ r_t(Mike)=\frac{3\%}{(1-15\%)}=3.53\% $$

$$ r_t(Mary)=\frac{3\%}{(1-20\%)}=3.75\% $$

Since the tax-equivalent yield of a municipal bond is dependent on the marginal tax rate, we got different figures for each client.

Mike should add the corporate bond to his portfolio because yield on the corporate bond (i.e. 3.70%) is higher than the tax-equivalent yield on municipal bond in his case (i.e. 3.53%). Mary should add the municipal bond, because its tax-equivalent yield for her portfolio (i.e. 3.75%) is higher than yield on corporate bond.

Written by Obaidullah Jan, ACA, CFA and last modified on