In general, municipal bonds fall into one of two categories—general obligation or revenue bonds. This categorization is based on the source of their interest payments and principal repayments. However, within these categories, a municipal bond can be structured in different ways, with each variation offering different benefits, risks, and tax treatments. While most investors think of municipal bonds as tax-exempt investments, this may not always be the case, as there are instances where the income generated by a municipal bond may be taxable. For example, a municipality may issue a bond that does not qualify for federal tax exemption, resulting in the income generated by that bond being subject to federal taxes. As a result of these different treatments, its important to consider all aspects of a municipal bond before making a purchase, rather than relying on its broad categorization.
General obligation bonds (GOs)
General obligation bonds are issued by governmental entities but are not backed by revenues from a specific project, such as a toll road. Some general obligation bonds are backed by dedicated taxes on property, while others can be payable from general funds. The latter types of bonds are often referred to as backed by the full faith and credit of the governmental entity. While in many instances, general obligation means that the issuer has unlimited authority to tax residents to pay bondholders, there are cases in which the issuer or governmental entity may have limited or no taxing authority.
Principal and interest payments for revenue bonds are secured by revenues generated by the issuer or by certain taxes such as sales, fuel, or hotel occupancy taxes. The only exception is when a municipality issues bonds as a conduit issuer. In those cases, while the municipality is the issuing entity, a third party is responsible for payments of both interest and principal. To learn more about conduit issuers, please see our section on Conduit bonds.
The issuers of revenue bonds are generally:
- Non-profit organizations (501(c)( 3)).
- Private-sector corporations (such as hospitals and universities).
- Entities that provide a public service (such as utilities and public transportation authorities).
Some municipal bonds are insured by policies written by commercial insurance companies. The insurance policy is intended to provide for the insurer to pay principal and interest payments to bondholders in the event the issuer defaults. Investors should take into account the creditworthiness of both the insurer and the issuer when considering insured bonds.
Taxable municipal bonds
The interest on some municipal bonds is taxable because the federal government will not subsidize the financing of activities that do not provide significant benefit to the public. Bonds issued to finance things like stadiums, replenishment of a municipality’s underfunded pension plan, or investor-led housing are a few examples of issues that would not qualify for federal tax exemption. Build America Bonds (BABs) are a recent category of taxable municipal bonds, introduced in the wake of the 2008 financial crisis. The advantage for issuers is that they receive a 35% federal rebate on interest costs for these bonds. BABs only subsidize an issuer’s borrowing cost. There is no implied backing from the federal government.
Zero-coupon municipal bonds are issued at an original issue discount, with the full value, including accrued interest, paid at maturity. Interest income may be reportable annually, even though no annual payments are made. Market prices of zero-coupon bonds tend to be more volatile than bonds that pay interest regularly.
Original-issue discount bonds
These are municipal bonds issued at a price below face value (par) which qualify for special treatment under federal tax law. The difference between the issue price and the face value is treated as tax-exempt income rather than as capital gains if the bonds are held to maturity.
Market discount bonds
When a municipal bond is purchased for less than its face value (par) in the secondary market, this is often referred to as a discount. Bonds may be sold at a discount for a variety of reasons, including changes in interest rates, changes in market conditions, a change in the issuers credit rating, or other events impacting the issuer. These bonds can also be referred to as market discount bonds, particularly when the amount of the discount exceeds a certain calculated amount specified under the Internal Revenue Code.
Pre-refunded bonds result from the advance refunding of bonds that are not currently redeemable. Once issued, the proceeds are placed in an escrow account set up to generate enough cash flow to pay interest and principal up to a specified call date. The goal is typically to provide present-value savings to the issuer, but in some cases can be used to change the indenture on the bonds. The escrow account is most often funded with U.S. Treasuries (although other instruments are sometimes used), in which case the pre-refunded bonds are considered relatively safe.
Escrowed-to-maturity (ETM) bonds
Bonds are escrowed to maturity when the proceeds of a refunding issue are deposited in an escrow account for investment in an amount sufficient to pay the principal and interest on the issue being refunded. In some cases, though, an issuer may expressly reserve its right to exercise an early call of bonds that have been escrowed to maturity. The escrow account is most often funded with U.S. Treasuries (although other instruments are sometimes used), in which case the escrowed bonds are considered relatively safe.
Housing bonds are securities backed by mortgages and mortgage loan repayments. Although not reflected as part of a traditional call schedule, these bonds can be called at any time from the prepayment of principal on the housing authoritys underlying mortgages, and therefore display as continuously callable and subject to extraordinary redemption (ER) provisions.
Municipal notes are short-term debt obligations which typically mature within a year or less, but may mature within two or three years. Municipalities issue notes to generate stable cash flow while they wait for other expected revenues. The types of municipal notes depend on the source of future cash flow, such as Tax Anticipation Notes (TANs), Revenue Anticipation Notes (RANs), and Bond Anticipation Notes (BANs).
These are revenue bonds issued by municipal agencies called conduit issuers that are third-party entities that act on behalf of the actual borrowers, typically private nonprofit (501(c)(3)) entities. Conduit bonds may be issued for projects such as nonprofit hospitals, housing developments, colleges and universities, transportation hubs, student loan programs, and public works projects. The third-party borrower—not the issuing conduit agency—is responsible for interest payments and principal repayments. The issuing agency generally is not obligated to use any other source to repay the bonds if the conduit borrower fails to make loan repayments. So, unless the official statements indicate otherwise, investors in conduit bonds should not view the issuing governmental agency as a guarantor on conduit bonds.