Municipal securities (or munis) are exempt debt securities issued by state and local governments in the United States and its territories. They include securities issued by agencies or authorities established by those governments. Munis are used to fund items such as infrastructure, schools, libraries, general municipal expenditures or refundings of old debt. When the United States introduced a federal income tax in 1913, the taxability of interest from municipal securities was challenged based on the constitutional principal of states' rights. That argument was upheld by the Supreme Court for much of the twentieth century but was finally rejected in a 1983 case. Today, congress has a right to tax interest income from municipal securities, but it currently chooses not to. Many states also exempt their securities from their own taxes, which makes those securities particularly attractive investments for their own residents. Of course, capital gains from buying or selling munis in the secondary market are fully taxed. Because of their tax-exempt status, munis have nominal yields below those of corporate bonds or Treasury bonds. To compare a muni's yield to that of a taxable bond, investors calculate the muni's tax-equivalent yield using the formula
This indicates the yield a taxable bond would have to earn in order to match, after taxes, the yield available on the untaxed muni. Here marginal tax rate is the tax rate that would apply to one additional dollar of income—if the investor earned one additional dollar, what fraction of that dollar would be lost to federal, state and local income taxes?
Consider an individual investor who pays a marginal tax rate of 34% due to federal, state and local income tax. To compare a muni paying 3% with a taxable corporate bond paying 4%, she would apply formula [1] to obtain a tax-equivalent yield for the muni of 4.55%. Barring other factors, she would likely invest in the muni, since its tax-equivalent yield is superior to the 4% yield on the corporate. Obviously, tax-equivalent yield depends on the investor's marginal tax rate. If a property and casualty insurance company is losing money, its marginal tax rate will be 0%. If it compares the same muni paying 3% and corporate paying 4% as in the previous example, it would apply formula [1] to obtain a tax-equivalent yield for the muni of 3%. Barring other factors, the company would probably invest in the corporate. Munis are not always tax exempt. Interest on some munis is taxed under the Alternative Minimum Tax (AMT). These are called AMT bonds. If a municipality issues debt to fund a commercial enterprise, such as a shopping mall or sports stadium, the securities are called private activity bonds. To prevent municipalities from engaging in tax arbitrage—issuing debt at tax-free yields while earning a commercial rate or return on the proceeds—interest on private activity bonds is taxable. To preclude tax arbitrage by securities dealers, any interest paid to finance a position in munis is not deductible as a business expense. Unlike, the Federal government, which can print money, municipalities cannot. This means that munis entail credit risk. There have been a number of spectacular municipal bankruptcies, so the risk of default is real. Munis are rated, just like corporate bonds, with ratings varying from AAA to D. Some munis are issued with credit enhancement. This may include credit insurance or a bank guarantee, such as a letter of credit. Long-term munis are called municipal bonds. These typically pay semiannual coupons, but some are zero-coupon or accrued-coupon bonds. These instruments fall into two general categories:
A third category of municipal bond is refunded bonds.
Municipalities issue a number of shorter-term instruments. Most common are municipal notes.
In the past, municipalities used commercial paper to meet much of their short-term funding needs. This had the advantage that municipalities didn't have to perform a new public offering each time they issued short-term debt. Municipal issuance of commercial paper was severely restricted by the 1986 Tax Reform Act. Since then, municipalities have turned to various floating rate instruments, which were first employed in the 1970s. These have long maturities, so issuers can have infrequent offerings. They also have liquidity features that make them essentially money market instruments.
While VRDOs and ARSs are unusual, most municipal securities are issued as traditional public offerings. There is an active over-the-counter secondary market for munis. Tax exempt investors, such as pension plans, don't generally invest in munis. Most munis are held by property and casualty insurance companies, wealthy individuals who have the highest marginal tax rate, and mutual funds that invest exclusively in munis. Banks or other dealers also hold inventories of municipal securities. The phrase tax-exempt bond refers to any bond whose interest is not subject to taxation by one or more authorities. In the United States, the term is often used synonymously with municipal bonds. However, non-profit entities like hospitals and museums also issue bonds that are tax exempt. These are structured much like munis, and they are sold to mostly the same investors.
|
||||||||||||||||||||||||||||||||||||||||||||||||||||||
