Municipal Bonds
Municipal bonds are issued by US states, cities and agencies, often with tax free interest. Learn GO vs revenue bonds, tax equivalent yield and the risks.
Municipal bonds, or munis, are debt securities issued by US states, cities, counties, school districts and public agencies to fund roads, schools, hospitals, water systems and other public projects. Their defining feature is that interest is usually exempt from federal income tax, and often from state and local tax for residents of the issuing state. That makes munis attractive to investors in high tax brackets, even though their stated yields are often lower than those of taxable bonds.
Types of municipal bonds#
| Type | Repaid from | Risk profile |
|---|---|---|
| General obligation (GO) | The issuer's taxing power | Generally lower risk; backed by taxes |
| Revenue bonds | Revenue from a specific project (tolls, water fees, hospital income) | Depends on the project's success |
| Private activity bonds | Projects benefiting private entities | May be subject to the alternative minimum tax |
| Pre refunded bonds | Escrowed Treasury securities | Very low credit risk |
Tax equivalent yield#
To compare a tax free muni with a taxable bond, investors calculate the tax equivalent yield:
tax equivalent yield = muni yield / (1 - marginal tax rate)Credit quality#
Municipal bonds have historically had much lower default rates than corporate bonds of the same rating, according to Moody's long term studies. But defaults do happen:
- Detroit (2013): the largest US municipal bankruptcy at the time, about $18 billion of debt, with losses for some bondholders and pensioners.
- Puerto Rico (2017): entered a bankruptcy like process under PROMESA with over $70 billion of debt, the largest in US municipal history.
- Revenue bonds for projects such as stadiums, hospitals and housing have higher default rates than general obligation bonds.
See Credit Ratings and Default Probability and Recovery Rate.
How munis trade#
The muni market is large (around $4 trillion outstanding) but fragmented: there are hundreds of thousands of different issues, many of which rarely trade. Trades are reported to the Municipal Securities Rulemaking Board's EMMA system, which provides free price and disclosure data. Many individuals hold munis through mutual funds and ETFs for diversification and easier trading.
Risks#
- Interest rate risk: like all bonds, munis fall when rates rise. See Duration.
- Credit risk: varies widely by issuer and bond type.
- Liquidity risk: many issues trade rarely, with wide spreads.
- Call risk: many munis are callable after 10 years.
- Tax law changes: changes in tax rates or exemptions affect muni values.
- Alternative minimum tax on some private activity bonds.
Who buys munis#
| Investor | Reason |
|---|---|
| High income individuals | Tax free income |
| Residents of high tax states | State tax exemption on in state bonds |
| Muni funds and ETFs | Diversified tax exempt income |
| Insurance companies and banks | Tax advantages and stable returns |
Frequently asked questions#
What are municipal bonds?#
Debt securities issued by US states, cities and public agencies to fund public projects, usually paying interest exempt from federal income tax.
What is tax equivalent yield?#
The yield a taxable bond would need to match a tax free bond's after tax return, calculated as the muni yield divided by one minus the tax rate.
Are municipal bonds safe?#
Many are high quality with low historical default rates, but defaults occur, especially in revenue bonds and distressed municipalities.
Next, learn about higher risk company debt in Investment Grade vs High-Yield Bonds.
Sources#
- MSRB, EMMA
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Mentioned in
- What Is a Bond?Markets and Instruments