Municipal Securities

A city needs a new sewer system. It borrows the money from investors and repays them over 20 years. That loan is a municipal security.

The exam asks two things about every muni: what pays you back, and how the interest is taxed.

What a municipal security is

A municipal security (a "muni") is a debt security issued by a state, city, county, or other government entity. Issuers sell munis to cover day-to-day obligations and to pay for capital projects such as schools, highways, and sewer systems.

A customer who buys a muni lends money to the issuer. The issuer promises interest, usually paid twice a year, and the return of the principal at maturity. Short-term munis mature in one to three years. Long-term munis run more than a decade.

GO bonds: the taxing power pays you back

A general obligation bond (GO bond) is backed by the full faith and credit of the issuer, which means the issuer's power to tax. No specific asset secures the bond. If the city runs short, it can raise taxes and pay you.

Because the whole tax base stands behind it, a GO bond draws on a broader pledge than a revenue bond tied to one project. Voters usually have to approve a new GO issue, because the debt binds the taxpayers.

Revenue bonds: the project pays you back

A revenue bond is repaid from the money one named project or source earns. Highway tolls, airport landing fees, water bills: whatever the project collects pays the bondholders. The taxing power stands behind none of it.

If the toll road stays empty, the money to pay you never arrives. Many revenue bonds are non-recourse: when the revenue dries up, bondholders get no claim on the underlying source.

A conduit bond is a revenue bond a municipal issuer sells for a private borrower, such as a non-profit hospital or college. The borrower repays the issuer, and the issuer pays the bondholders. If the borrower defaults, the issuer usually owes the bondholders nothing.

The other municipal types

Three more kinds show up on the exam.

A special tax bond is repaid from one named tax, such as a tax on fuel, tobacco, or hotel rooms. It works like a revenue bond, with a tax stream in place of a project.

A taxable municipal security pays interest that the federal government taxes. Issuers sell these when the project fails the federal test for tax exemption. Pension funding and sports stadiums are common reasons. Build America Bonds are the best-known example, though the program closed to new issues at the end of 2010.

A short-term municipal note covers a gap in cash flow and matures in about a year or less. The name tells you what repays it:

• A tax anticipation note (TAN) waits for tax collections.
• A revenue anticipation note (RAN) waits for other revenue.
• A bond anticipation note (BAN) waits for the long-term bond issue that refinances it.

The tax break and what it is worth

Interest on most munis is exempt from federal income tax. If your customer lives in the state that issued the bond, the interest is often exempt from state and local income tax too.

The break has edges, and the exam tests them:

• Only the interest escapes tax. A capital gain from selling a muni above its cost is taxable.
• Interest on some munis, mostly private activity bonds, counts under the federal alternative minimum tax (AMT).
• An out-of-state buyer keeps the federal exemption but usually still owes state tax on the interest.

Since the interest escapes federal tax, munis pay lower stated yields than corporate bonds of similar maturity and credit quality. Compare the two with the tax-equivalent yield: divide the muni yield by 1 minus the investor's federal tax rate. A 4% muni for a customer taxed at 32% equals 4 divided by 0.68, or 5.88% from a taxable bond. The muni wins for this customer.

Who buys municipal bonds

Munis suit a customer who wants a steady stream of income and cares more about keeping wealth than growing it. That customer also pays a high tax rate, so the exemption is worth real money.

A customer in a low tax bracket usually keeps more after tax from a corporate bond. Munis also fit poorly inside an IRA or another tax-deferred account. That account already defers the tax, so the customer gave up yield for nothing.

The official statement

The official statement is the disclosure document for a new municipal offering. Municipal securities are exempt from SEC registration, so the issuer publishes this instead of a prospectus. It describes the issue, the security behind it, the issuer's finances, and the risks.

Under SEC Rule 15c2-12, an underwriter must obtain the official statement from the issuer. The underwriter must also get the issuer to promise ongoing disclosure. That covers annual financial information plus events such as defaults and rating changes.

The MSRB posts official statements and continuing disclosures free on EMMA (Electronic Municipal Market Access). The SEC named EMMA the official repository in 2009. Neither the SEC nor the MSRB reviews these documents before they appear. The exam loves this trap.

How this gets tested

Most items hand you a fact pattern and ask for the repayment source or the tax result. Sort them this way:

• Backed by the taxing power and full faith and credit: GO bond.
• Backed by one project's earnings: revenue bond.
• Backed by one named tax: special tax bond.
• Federal tax free, and state tax free at home: ordinary muni interest for an in-state resident.

A sample of the logic: "A city funds a parking garage with bonds repaid from parking fees. What type is it?" A revenue bond. The garage pays, not the taxpayer.