DEFINITION of Municipal Note

A municipal note is debt issued by state and local governments to finance capital expenditures, such as construction projects. Municipal notes are appealing to investors because they mature in one year or less, offer fixed income, and are often exempt from income tax at the federal and/or state levels.

BREAKING DOWN Municipal Note

When local or state governments decide to raise funds to finance a project that would benefit the region, they typically opt for municipal notes. Municipal notes are short-term debt securities issued with maturity terms of 12 months, although maturities can range from three months to three years. A city, for example, may issue a municipal note to raise capital to finance a new park in the city.

Municipal notes are usually issued in anticipation of tax receipts, revenue, or proceeds from a bond issue. Three types of municipal notes are:

  • Bond Anticipation Notes (BAN): These notes are issued in anticipation of long-term financing which when issued is used to retire or pay off BANs. A borrowing entity that is due to commence work on a new project may decide to issue long-term bonds to finance the project. However, the issuance of these bonds may not be possible prior to the launch of the project due to certain legal, regulatory, or compliance procedures that could cause a delay in issuing new bonds. In order to proceed with work on the new project and to have the funds necessary to finance the project, the governmental issuer may decide to issue short-term municipal notes as a source of financing in the interim. ¬†When the long-term bonds are issued, the proceeds are used to make the interest and principal payments on the bond anticipation municipal notes.
  • Tax Anticipation Notes (TAN): The interest and principal payments of these municipal notes are secured by future tax revenue. TANs are issued by states or municipalities to finance current operations before tax revenues are received. When the issuer collects the taxes, the proceeds are then used to retire the tax anticipation notes.
  • Revenue Anticipation Notes (RAN): These securities are municipal notes whose interest and principal payments are secured by the anticipated non-tax revenue of a project. When the project is completed and starts generating revenue at a future date, the revenue is used to pay off the RAN.

Whereas a majority of municipal bonds make an interest payment semi-annually, municipal notes tend to make only one payment upon maturity, which includes both interest and principal payment obligations.

Municipal notes usually pay lower coupons than corporate notes with similar maturities, but because the yield is tax-free, the after-tax basis may be higher for a municipal bond. Municipal notes are exempt from federal income taxes and, sometimes, from state and local taxes as well.

Investors can determine the risk of investing in a particular municipal note by examining the ratings issued by Moody's and by Standard & Poor's. Moody's gives municipal notes three possible ratings: MIG 1 (best quality), MIG 2 (high quality), and MIG 3 (adequate quality). Standard & Poor's uses a four-tiered rating system: SP-1+, SP-1, SP-2 and SP-3. Only the first three are considered worth investing in. SP-3 municipal notes are considered speculative.