Municipal Bonds

Municipal bonds are the bonds that are issued by cities, countries, government entities below the state level, airports and ports to collect funds for developing infrastructure like roads, buildings and schools and other obligations.

Municipal bond holders do not have to pay federal income tax and start income tax on the interest received by them. However municipal bonds that are created with specific purposes are not exempted from tax.

Municipal bonds provide interest at either variable rate of interest or fixed though there is a limit above which interest cannot be paid to the bond holders. The bodies or government entities which issue Municipal Bonds get cash from the bond holders and utilize it to pay for major projects. Funds accumulated from the sale of Municipal Bonds have to be spent on the projects within three to five years after the bonds are issued. However, in some cases, funds raised from Municipal Bonds can be used for maintenance expenditure or giving funds for student loans.

Since Municipal Bonds are exempted from payment of tax, investors have no problem in getting lower interest rates, making Municipal Bonds an attractive and cheaper way of collecting funds for those issuing such bonds as they have to pay low interest rates.

Municipal Bond holders can buy bonds either from primary market i.e. buy the bonds directly when they are issued or from the secondary market i.e. buy the bonds from the other investors. Usually, many bond holders receive payment of interest half-yearly. However, in case of short term municipal bond holders will get the interest along with its principal only at the time of maturity of the bonds. 

Types of Municipal Bonds

  1. General obligation bonds: In general, obligation bonds, the issuer of the bond promises to repay the investor the interest and the principal amount from its kity. Such bonds are generally very secure and provide lowest interest on the principal amount.
  2. Revenue bonds: In revenue bonds, the issuer of the bonds promises to repay the investor from a particular source of income such as revenue generated by electricity department.
  3. Assessment bonds: In assessment bonds, the investor gets repaid through the assessment of the property tax within the jurisdiction of the bond issuer.

    In United States, Zero Coupon Municipal Bonds are also issued which, unlike other Municipal Bonds which pay interest half-yearly, do no pay interest until the maturity period. Like other Municipal Bonds, the interest paid to the investor is exempted from the taxes.

Features of Municipal Bonds:

  1. Taxability: The most attractive feature of the Municipal Bonds is that they are exempted from payment of taxes. Investor in Municipal Bonds does not have to pay federal taxes, state or local taxes on the interest received by him. Only, in some cases, in which the Municipal Bonds have been issued for a particular purpose, investor has to pay minimum tax. A law firm has to certify whether a particular Municipal Bond is tax exempt or taxable before it is launched in the market. It is important for the investor to know beforehand whether the Municipal Bond he is purchasing is tax exempt or not.
  2. Risk Factor: The risk factor of Municipal Bonds relate to the fact whether the bond issuer would be able to repay the investor. An independent credit rating agency is generally hired by the issuer to give rating to the bond. The higher the rating, more secure is the Municipal Bond. A person interested in buying a particular bond needs to know rating given to the bond to negate any risk involved in buying the bond.

    Another risk involved in buying Municipal Bonds is that in case, the interest rate prevailing in the market is high; the investor will get low interest rate only as prescribed in the agreement. Also, if the issuer of the Municipal Bond is a small entity, the risk factor would be more as compared to the bonds issued by a large and credit-worthy entity.

  1. The issuer of the bond needs to divulge to its potential investors about the repayment schedules, tax-exempt status, and rating by an independent rating agency and financial and other important information. Also, after the issuance of the bonds, the issuer should continue giving updates on any change in rating or other such information.

    If one compares taxable corporate bonds with tax-free Municipal Bonds, he may find that the tax-free Municipal Bonds will provide more yield after paying the taxes in comparison with the high-interest paying corporate bonds as the taxes paid by the corporate bond holder will decrease the net income. 

Municipal Securities Rulemaking Board (MSRB):

    Established in 1975, the board regulates all the dealers of the Municipal Bonds, municipal securities and the municipal notes in order to protect interests of bond holders and public at large. The board makes rules for the dealers, while implementation of the rules formulated by the board is done by the Securities and Exchange Commission.