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.

NOTE:
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

Introduction


Related Articles
  1. Taxes

    Taxation Rules For Bond Investors

    Several factors affect the taxable interest that must be reported. Learn more here.
  2. Bonds & Fixed Income

    The Basics Of Municipal Bonds

    Investing in these bonds may offer a tax-free income stream but they are not without risks.
  3. Home & Auto

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  4. Bonds & Fixed Income

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
  5. Bonds & Fixed Income

    Muni Bonds, Taxable Bonds or CDs: Which is Best?

    Here's how to tell if municipal bonds are a better investment than taxable bonds or CDs.
  6. Financial Advisors

    Top 4 Ways to Avoid Muni Bond Mistakes

    Muni bonds are often perceived as safe investments. But it's important to do some thorough research before investing.
  7. Professionals

    Zero-Coupon and Municipal Bonds

    Zero-Coupon and Municipal Bonds
  8. Bonds & Fixed Income

    A Look at the Pros and Cons of Muni Bonds

    Considering muni bonds? Here's a look at their pros and cons.
  9. Mutual Funds & ETFs

    Why Muni Bonds and Bond Funds are Perfect Together

    Municipal bonds and bond funds differ in several ways, which is partly why they complement each other well.
  10. Options & Futures

    20 Investments: Municipal Bonds

    What Is It? Municipal bonds, or "munis" for short, are debt securities issued by a state, municipality or county to finance its capital expenditures. Such expenditures might include the construction ...
RELATED TERMS
  1. Taxable Municipal Bond

    A fixed-income security issued by a local government such as ...
  2. After-Tax Basis

    A comparison of the net yields produced by taxable and tax-exempt ...
  3. Fully Taxable Equivalent Yield

    The yield on a municipal bond, when the effect of reduced taxes ...
  4. Tax-Equivalent Yield

    The pretax yield that a taxable bond needs to possess for its ...
  5. Bond

    A debt investment in which an investor loans money to an entity ...
  6. Municipal Bond

    A debt security issued by a state, municipality or county to ...
RELATED FAQS
  1. How are municipal bonds taxed?

    Discover information about trading municipal bonds, specifically the various tax implications municipal bonds have at state ... Read Answer >>
  2. What do cities do with the funds generated from municipal bonds?

    Learn more about municipal bonds, including the various types of bonds issued and the purposes of municipal bond funds, such ... Read Answer >>
  3. How do the returns on municipal bonds compare to those of other bonds?

    Learn how tax-free municipal bonds may provide better returns than other types of bonds, and understand the risks of municipal ... Read Answer >>
  4. Who or what is backing municipal bonds?

    Learn about the basics of municipal bonds, including the various revenue sources that are utilized to back or secure municipal ... Read Answer >>
  5. Where can I buy government bonds?

    The type of bond determines where you can purchase it, so you need to decide which type of bond you would like to purchase ... Read Answer >>
  6. What forms of debt security are available for the average investor?

    Discover the various different types of debt securities, issued by government entities or corporations, that are available ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center