Cash Equivalents and Fixed Income Securities - Municipal Bonds

Municipal bonds (often referred to as muni bonds) are issued by state, city, and county agencies and provide interest that is tax-free at the federal level. The interest may also be tax-free at the state level if the owner of the bonds is a resident of the state that issued the bonds.

Due to this tax-free interest, it's important to understand yield equivalence so you can easily compare tax-free versus taxable interest rates. To convert a muni bond yield to its taxable equivalent, simply divide the interest rate by the inverse of the potential investor's marginal tax bracket.

Taxable Equivalent Yield = Coupon Rate
(1-marginal tax rate)

For example, if a muni bond is paying 4% interest and the investor is in the 25% tax bracket, divide 4% by .75 for a taxable equivalent yield of 5.33%.

Taxable equivalent yield = .04/(1-.25) = .04/.75 = .0533 or 5.33%

You can then compare the muni to taxable (government or corporate) bonds of similar maturity and risk. If other bonds pay less than 5.33%, the muni offers an advantage.

Municipal bonds are issued as one of two types:

  • General Obligation Bonds - GO
    • These bonds are backed by the full faith and credit of the issuer.
    • GOs carry less risk, since the issuer can collect (and thus, if necessary, raise) taxes to service the debt.

  • Revenue Bonds
    • These are used to finance specific projects, such as an airport or sports facility.
    • Revenue bonds are backed only by the fees generated by the facility - if they are insufficient, the bonds could go into default.

Since 1986, some bonds issued by a municipality are no longer tax-exempt. Only those classified as public-purpose bonds offer tax-exempt interest. Others, known as private-purpose bonds, are fully taxable, unless their use is specifically exempted. Private-purpose bonds include those issued to finance convention centers, sports facilities and industrial development. Permitted private-purpose bonds that are exempt from regular federal income tax are still subject to the Alternative Minimum Tax (AMT).

Exam Tips and Tricks
Consider this sample exam question:

  1. Which of the following types of municipal bonds would probably not offer tax-exempt interest?
    1. To fund a new bridge
    2. To fund a new school
    3. To fund a new convention center
    4. To fund a new sewer system

The correct answer is "c", since this is an example of a private-purpose bond

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