Municipal Bond Basics
Municipal bonds ("munis") are debt securities issued by state and local governments to finance public projects. Their primary advantage is tax-exempt interest income at the federal level, making them particularly attractive to high-income investors.
Types of Municipal Issuers
| Issuer Type | Examples |
|---|---|
| States | State general funds, state agencies |
| Local governments | Cities, counties, townships |
| Special districts | School districts, water districts, fire districts |
| Authorities | Port authorities, housing authorities, transit authorities |
Tax-Exempt Status
The interest income from most municipal bonds is exempt from federal income tax. This is the primary reason investors buy municipal bonds.
Triple Tax-Free
Municipal bonds can be "triple tax-free" if:
- Interest is exempt from federal income tax
- Interest is exempt from state income tax (usually for residents of the issuing state)
- Interest is exempt from local income tax
Exam Tip: A California resident buying a California municipal bond receives triple tax-free income. But if they buy a New York municipal bond, only the federal exemption applies.
Tax-Equivalent Yield (TEY)
Since municipal bond interest is tax-free, you need to calculate the tax-equivalent yield to compare munis to taxable bonds fairly.
The Formula
Tax-Equivalent Yield = Municipal Yield ÷ (1 - Tax Rate)
Example Calculation
A municipal bond yields 4%. An investor is in the 37% federal tax bracket.
TEY = 4% ÷ (1 - 0.37)
TEY = 4% ÷ 0.63
TEY = 6.35%
Interpretation: A taxable bond would need to yield 6.35% to provide the same after-tax return as this 4% municipal bond.
Key Points
- Higher tax bracket = greater benefit from tax-exempt bonds
- The TEY is always higher than the municipal yield
- TEY helps compare apples to apples (muni vs. corporate/Treasury)
Alternative Minimum Tax (AMT) Bonds
Some municipal bonds are subject to the Alternative Minimum Tax—a parallel tax system that limits certain deductions.
Private Activity Bonds
Municipal bonds used to finance "private activities" (airports, stadiums, industrial development) may be subject to AMT.
Key Points:
- Interest is still exempt from regular federal income tax
- Interest IS included when calculating AMT
- AMT bonds typically offer higher yields to compensate for potential tax liability
- 2025 AMT exemption threshold: $1,252,700 (married filing jointly)
Who Should Avoid AMT Bonds?
- High-income investors subject to AMT
- Consider "AMT-free" municipal funds if AMT is a concern
Municipal Bond Market Structure
Primary Market
- Negotiated underwriting: Issuer selects underwriter; most common method
- Competitive underwriting: Issuers accept sealed bids; lowest interest cost wins
- Private placement: Bonds sold directly to institutional investors
Secondary Market
- Over-the-counter (OTC): Most municipal bonds trade OTC, not on exchanges
- EMMA: Electronic Municipal Market Access—MSRB's free platform for muni data
- Municipal bonds are generally less liquid than Treasuries or corporate bonds
Municipal Bond Characteristics
| Feature | Description |
|---|---|
| Interest payments | Usually semiannual |
| Minimum denomination | Typically $5,000 |
| Maturities | Range from 1 to 30+ years |
| Call features | Many munis are callable |
| Quotes | Typically quoted on a yield basis (yield to maturity) |
An investor in the 32% federal tax bracket is considering a municipal bond yielding 3.5%. What is the tax-equivalent yield?
Which of the following municipal bonds would be subject to the Alternative Minimum Tax (AMT)?
A California resident purchases a municipal bond issued by the State of New York. The interest income is:
4.2 General Obligation Bonds
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