4.1 Municipal Bond Basics

What Municipal Bonds Are

Municipal bonds ("munis") are debt securities issued by states, their political subdivisions, and certain authorities to finance public projects such as schools, highways, water systems, and airports. The Series 7 tests munis heavily because their tax treatment, security structures, and the Municipal Securities Rulemaking Board (MSRB) rule set are unique among the products you can sell.

The defining feature is federally tax-exempt interest income. Coupon interest on most munis is excluded from gross income under Section 103 of the Internal Revenue Code. That exemption applies to interest only — any capital gain from selling a muni above its cost basis is fully taxable, and a bond bought at a discount can generate ordinary income or capital gain at maturity.

Tax-Exempt Status and "Triple Tax-Free"

State and local taxation depends on residency. A bond is triple tax-free for an investor only when interest is exempt at the federal, state, AND local level — and that normally requires the investor to live in the issuing state.

• A California resident buying a California bond receives triple tax-free income.
• The same California resident buying a New York bond keeps the federal exemption but owes California state tax on the interest.
• U.S. territory bonds (Puerto Rico, Guam, U.S. Virgin Islands) are exempt in all states — this is a classic exam trap.

Exam Tip: Treasury interest is the mirror image — federally taxable but state/local tax-exempt everywhere. Don't confuse the two.

Tax-Equivalent Yield (TEY)

Because muni interest is tax-free, you cannot fairly compare it to a corporate or Treasury yield without grossing it up. The tax-equivalent yield is the pre-tax yield a taxable bond would need to match the muni's after-tax return:

$\text{TEY} = \frac{\text{Municipal Yield}}{1 - \text{Tax Rate}}$

Worked example. A muni yields 4% and the investor is in the 37% federal bracket. TEY = 4% / (1 - 0.37) = 4% / 0.63 = 6.35%. A taxable bond must yield 6.35% to leave this investor as well off. Note three rules the exam loves:

• The TEY is always higher than the stated muni yield.
• The higher the tax bracket, the larger the benefit — munis suit high-income clients, not IRAs or low-bracket investors.
• To run it the other way (taxable equivalent of a muni), use the after-tax yield formula: Taxable Yield × (1 - Tax Rate).

Alternative Minimum Tax (AMT) and Private Activity Bonds

The Alternative Minimum Tax is a parallel federal tax that recaptures certain preference items. Interest on a private activity bond (PAB) — one where more than 10% of proceeds benefit a private user, such as an airport terminal leased to airlines, a sports stadium, or an industrial development bond — is a tax preference item added back when computing AMT.

• The interest is still exempt from regular federal income tax.
• It IS counted when calculating AMT liability, so an AMT-exposed investor may owe tax on it.
• PABs therefore carry higher yields to compensate, and "AMT bonds" are unsuitable for clients already subject to AMT.
• Section 501(c)(3) bonds (hospitals, private universities) and governmental-purpose bonds are NOT AMT preference items.

Primary Market: How Munis Are Brought to Market

Secondary Market and Quoting Conventions

There is no central exchange for munis — they trade over-the-counter through dealers, and the market is less liquid than Treasuries. Key conventions:

• Settlement is regular-way T+1, the same as most securities since 2024.
• Most munis are quoted on a yield basis ("5.00 of 2040 yielding 4.20"), called a basis quote. Short-term notes and some dollar bonds are quoted as a percentage of par.
• The Electronic Municipal Market Access (EMMA) system, run by the MSRB, provides free real-time trade prices and disclosure documents.

Exam Tip: Munis carry no SEC registration (exempt under the Securities Act of 1933) but ARE subject to the antifraud provisions and to MSRB rules.

Notes, Anticipation Securities, and Maturity Structures

Not every muni is a long-term bond. Issuers raise short-term cash with anticipation notes, usually maturing within twelve months, repaid from a specific future inflow:

Long-term issues come in three maturity structures the exam tests by name. A serial issue matures in installments across many years (common for GO deals). A term issue matures all on one date, often supported by a sinking fund. A balloon structure blends serial maturities with a large final term maturity. Serial bonds let an issuer match repayment to a level annual debt-service budget.

Variable-Rate and Original-Issue-Discount Munis

Two specialized structures appear in suitability questions. A variable-rate demand obligation (VRDO) resets its coupon periodically and lets the holder "put" the bond back at par, giving money-market-like liquidity. An original-issue-discount (OID) muni is sold below par; on a tax-exempt OID, the annual accretion of that discount is treated as tax-exempt interest, not as a taxable capital gain — a frequently tested distinction from a bond bought at a discount in the secondary market, where the accreted discount is taxed as ordinary income.