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Municipal Bonds 101

Safety and tax exemption are traditional hallmarks of the asset class, but the market has many challenges.

Jeff Westergaard, 08/28/2012

The municipal-bond market is one of the mainstays of fixed-income markets for U.S. investors. Muni bonds provide the means by which state and local governments and charitable organizations raise capital to fund all manner of needs. For investors, munis offer two primary benefits: low default occurrence and interest that is usually exempt from federal taxation.

In addition, the market is characterized by its incredible diversity of both issuers and individual bonds. There are more than 100,000 unique issuers and 1.5 million individual bonds outstanding, staggering numbers in relation to any other securities market. Taken together, these aspects make the muni-bond market unique among investable asset classes. Here’s a primer on the muni-bond market.

A Promise to Pay
Municipal bonds are debt instruments, meaning that the municipal issuer is borrowing money from the bond investor. The issuer stipulates the amount of interest to be paid, the date at which principal will be repaid, and the conditions that will be employed to provide security of repayment. All of these are determined at the time of issuance and are codified in an offering document called the official statement. The means by which any given muni issuer can provide payment security covers a wide range and, for state and local government issuers, will be determined by what the state legal code allows. At a broad level, these means of repayment are usually categorized as being one of the following:

  • General obligations: a promise by the issuer to treat the debt obligation as payable from any legally available source, in the case of local governments often from property tax revenues.
  • Revenue bonds: bonds secured by specifically assigned sources of payment, often times from business like enterprises, such as a water or sewer system.
  • Leases/certificates of participation: bonds or fractional ownership interests in lease payments made by an obligor, including administrative buildings, correctional facilities and university buildings.

The market generally considers general-obligation bonds to be the least risky category. Overall, though, the level of defaults for munis historically is low, many orders less than those of corporate bonds.

Municipal-Bond Issuers
Issuers, or more correctly “obligors,” fall into one of three categories: state and local governments; charitable organizations; or private activity organizations.

The first category includes states and their agencies, cities, counties, towns, school districts, and special districts such as parks or utilities. It is the largest category both in terms of issuers and of bonds outstanding.

Charitable organizations consist primarily of hospital and educational organizations that are designated as nonprofit. This is a large compo- nent of the municipal market with significant amounts of bonds outstanding.

Private activity bonds are paid by entities that generally exist to make commercial profits such as corporations. The usual type of issues in this category is for economic development or pollution control purposes.

Tax Treatment
Municipal bonds are the only significant asset class that offers tax advantages to investors in the form of interest that is generally exempt from income taxation. Due to reciprocity agreements, states cannot tax U.S. Treasury debt interest and the Internal Revenue Service does not tax qualifying municipal-bond interest. The tax exemption of interest is a defining charac- teristic of munis, although not all bonds qualify.

A small subset of issues is subject to the alternative minimum tax. This means that the interest on these bonds must be included as a preference item when calculating the AMT for individuals. Because of the uncertainty to investors that this can cause, bonds in the AMT category generally carry higher interest rates that non-AMT bonds.

There are other muni issues that are federally taxable. For most of the past 50 years, these were an insignificant part of the market. With the advent of the Build America Bond program in 2009, however, taxable muni issuance skyrocketed through 2010, when the BAB program ended.

Who Buys Them?
Because of the combination of safety of principal and tax-exemption, municipals are the one asset class that is predominantly held by individual investors, especially wealthy individuals. Around 60% of outstanding municipal debt is held by individuals either directly or in an investment vehicle such as a mutual fund.

The major institutional classes of muni inves- tors are insurance companies and banks, both of which are able to take advantage of tax benefits by holding munis.

Recent Market Turmoil
For many years municipals were viewed as a safe, relatively boring, asset class. Most of the outstanding debt in the market was rated AAA, in large part because of third-party bond insurance. Then, the financial crisis happened and the relatively sanguine muni market was thrown for a loop.

Since the crisis and resulting recession, municipal governments have experienced a severe degree of fiscal pressure, the likes of which haven’t been seen since the Great Depression. This has led to many dire predictions about the market in general and the safety of the asset class.

To date, these predictions have not come to pass, but there is no denying that analysis of credit quality and differentiating between obligors is now critically important for investors in a way that is has not been for quite some time.

Caution Is Key
The municipal-bond market offers investors many unique properties with which to achieve their financial goals. Safety and tax exemption, the twin hallmarks of the muni market, combine to provide investors with a way to generate income, maintain wealth, and oftentimes generate superior after-tax returns.

However, the market is very diverse and much more complex than other markets. Navigating these challenges can be difficult for many investors. Careful analysis of both credit quality and price discovery is key to getting successful investment outcomes.

Jeff Westergaard is Morningstar’s director of municipal analytics.

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