Municipal Bonds

Municipal bonds (“munis”) are issued by state and local governments to fund the construction of schools, highways, housing, sewer systems, and other important public projects. 

These bonds tend to be exempt from federal income taxes and, in some cases, from state and local taxes for investors who live in the jurisdiction where the bond is issued. 

Munis tend to offer competitive rates but with additional risk because local governments can go bankrupt.

Note that, in some states, investors will have to pay state income tax if they purchase shares of a municipal bond fund that invests in bonds issued by states other than the one in which they pay taxes. 

In addition, although some municipal bonds in the fund may not be subject to ordinary income taxes, they may be subject to federal, state, or local alternative minimum tax. 

If an investor sells a tax-exempt bond fund at a profit, there are capital gains taxes to consider.

There are two basic types of municipal bonds. 

General obligation bonds are secured by the full faith and credit of the issuer and supported by the issuer’s taxing power.

General obligation bonds are issued to pay for projects such schools and sewer systems. Most investors consider general obligation bonds safer than their revenue counterparts; this is a misconception.

Revenue bonds are repaid using revenue generated by the individual project the bond was issued to fund.

Revenue munis, on the other hand, are issued by special state or local-government sanctioned entities (such as a utility company). 

The interest is serviced (i.e., paid) by the revenue generated from the business that backs the obligation. In the case of a water company, bond holders are paid out of the cash generated from customers paying their water bills.

There is very little information available concerning individual municipal bonds this forces investors to rely heavily on the credit ratings assigned by various credit agencies. 

To help ensure the safety of their investment, bond holders should find out 1.) who is responsible for servicing the interest payments on the bonds, and 2.) the underlying economics of the issuer. 

Is it a blossoming community with a growing, high-net worth citizen base, or a deteriorating metropolis with lower-income demographics?  All of these factors should be of concern. In the 1942 edition of Security Analysis, Benjamin Graham recommended municipal bonds possess the following characteristics:

1. Population of 10,000 or greater
2. Diverse economy
3. History of punctual payment on past obligations