Municipal Securities

This section goes into detail about the basics of municipal securities and the characteristics of municipal bonds. It also discusses the different types of municipal securities in the market and includes detailed information on prices, yields, and tax-exempt status.

Municipal bonds are interest-bearing securities issued by state and local governments to finance specific projects. Due to the fact that the interest is exempt from federal tax and also sometimes at the state and local levels, they are also referred to as tax free bonds. When the security reaches its maturity, the par value, face value, or principal amount, is what is paid to the investor. The interest is paid to the investor throughout the life of the security. A municipal bond typically matures anywhere from 1 to 40 years, but some bonds have been issued with maturity dates set as high as 100 years.

A long-term financial instrument is considered anything with a maturity rate of over a year; a short-term instrument is considered anything less. Short-term instruments include notes and commercial paper. Zero coupon bonds pay the full amount of interest at the date of maturity, as opposed to paying it periodically throughout the life of the bond.

The Specifics of a Bond

There are six key characteristics, or pieces of information, that define a bond:

  • Name of the Issuer - Identifying the issuing party is essential so that investors know where their money is going and where their bonds are coming from.
  • Coupon - The coupon is the interest rate stated on the bond and is payable to the bondholder. Municipal bonds may have either a fixed or variable rate, either one being stated on the bond.
  • Maturity Date - The exact day, month, and year that the bond will reach its full maturity and the time at which the investor can receive their principal amount back.
  • Dated Date - The exact day, month, and year that the bondholder will begin to accrue interest on their bond.
  • Yield and Price - Municipal bonds are typically quoted in terms of yield to maturity. The price of the bond is stated as a percentage of the par value.
  • CUSIP Number - The CUSIP number is a unique number that identifies a bond. It is made up of nine characters. The first six digits are known as the issuer number. The next two-character suffix is the issue number. The ninth and final digit is a check number.

All bonds are required to have this information printed on them at the time they are issued; it serves to help the investor understand their investment more clearly as well as serving as a permanent record of the history of the transaction and the bond itself.

Yield and Price

A direct relationship exists between price and yield for municipal bonds. They fluctuate in yield due to economic conditions such as Federal Reserve monetary policy and inflation, among others. The yield is the interest rate while the price specifies the price of a given bond, which may either be above or below the par amount. A discount bond will trade for less than the par value; for example, a discount bond with a $100 par value may trade at $98. On the other hand, a premium bond will trade above the par amount; for example, a premium bond with a par value of $100 may trade at $103. For more information, please visit the Yield & Price section of this site.

Types of Yields

  • Yield to Maturity - Takes into account the time value of money. Municipal bonds are bought and sold on the basis of yield to maturity.
  • Yield to Call - The annual return, compounded semiannually, that an investor would earn from payments of principal and interest.
  • Yield to Worst - The lowest possible yield that a bond can have.
  • Current Yield - This is a way to calculate the current income on a bond. Current yield is equal to the coupon interest payment divided by the current price of the bond. This method does not take into account the time value of money and interest-on-interest and therefore municipal bonds are not sold on the basis of current yield.

Federal Tax Exemption on Municipal Bonds

The interest accrued on municipal bonds has traditionally been exempt from federal taxation, which is why they are commonly referred to as tax exempt bonds. Because of this, investors are willing to accept lower yields on their investment; they gain their real advantage in the tax exemption, particularly if they are in a higher tax bracket.

State Taxation

In addition to being exempt from federal taxation, municipal bonds are often exempt from state and local taxation. However, states usually only grant such exemption for bonds issued within their own state.

Types of Municipal Bonds

The municipal bond market is composed of bonds that serve diverse purposes and that offer different security features to investors, characteristics for which it is recognized. In general, municipal bonds are subdivided into two major categories revenue bonds and general obligation bonds.

  • Revenue Bonds are issued to finance a specific revenue-generating project and are typically secured exclusively by the revenue of that project, unless a third party further guarantees security. Examples of projects financed by revenue bonds include toll booths, airports, and health care facilities.
  • General Obligation Bonds are secured by the credit and taxing power of the local or state government. These types of bonds insure that all their revenue will be used to pay the debt on the issued bonds.

Short-term Securities

Local and state governments may resort to the issuance of short-term securities to help them get through the lag of income that exists between the accumulation of expenses and the generation of revenue.

Notes

Local and state governments often issue the following types of notes:

  • Tax Anticipation Notes- TAN’s are issued in anticipation of tax receipts, most often property taxes, and are payable from those receipts
  • Revenue Anticipation Notes - RAN’s are issued in anticipation of additional sources of revenue in the future
  • Bond Anticipation Notes - BAN’s provide a means of financing in anticipation of a future bond offering
  • Grant Anticipation Notes - GAN’s are issued in anticipation of grants and are payable once said grants have been received
  • General Obligation Notes - Local and state governments may issue these notes for a variety of purposes and are fully backed by their own credit

Tax-Exempt Commercial Paper

Short-term promissory notes issued for periods up to 270 days, but with common maturity dates set at 30, 60, and 90 days. They are used for the same purposes as notes, but they offer an advantage in flexibility for setting maturities and rates.

Variable-Rate Demand Obligations

Short-term municipals are bonds with traditional long maturity dates but also include short-term demand features. The investor is assured the principal while the issuer is able to borrow at a lower rate.