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The Mystery of Municipal Bonds: Why Are They So Attractive to High-Tax Investors?
Municipal bonds, or "munis," are bonds issued by state or local governments or entities they create, such as agencies and special districts. In the United States, the interest income that holders receive from municipal bonds is generally, though not always, exempt from federal and state income taxes. That leaves only investors in the highest tax brackets who can truly benefit from buying tax-free municipal bonds. Investors need to perform a taxable equivalent return calculation to fairly compare the two types of bonds.
As of the first quarter of 2021, total municipal debt in the U.S. municipal debt market was approximately $4 trillion, compared to nearly $15 trillion in debt in the corporate and foreign markets.
While the total amount of municipal debt is relatively small, the size of the market being returned is significant. In many other countries, local authorities issue similar bonds, sometimes called local authority bonds. In fact, the history of municipal bonds dates back centuries; local government borrowing in the United States dates back to the 19th century, and municipal bonds appeared as early as the early 1800s. The General Obligation Bonds issued by New York City in 1812 are considered the first municipal bonds in official records.
However, the development of this market has not been smooth sailing. In the 1840s, many American cities were burdened with huge debts, a process that highlighted the need for rapid urbanization. Municipal debt has grown as cities have grown and public education systems have expanded. After an economic crisis in 1868, many local governments' debts were reregulated, leading to a continued growth in municipal debt to this day.
Types of Municipal Bonds
Municipal bonds can be divided into several main types:
General Obligation Bonds: Bonds whose principal and interest are guaranteed by the full faith and credit of the issuer and are usually backed by unlimited or limited taxing powers.Assessment Bonds: Bonds that promise to be repaid based on the proceeds of property tax assessments within the issuer's boundaries. These bonds are usually in the form of general obligation bonds.Revenue bonds: Based on the repayment of a specific future revenue stream, such as revenue from a public utility.
In 2020, approximately 80% of U.S. municipal bond trading volume was in tax-exempt securities.
The issuance process of municipal bonds involves necessary supervision and procedures. In some cases, particularly involving property tax levies, voter approval may be required. However, for small or emergency projects, prior voter approval may not be required. Whenever a municipal bond is issued, the issuer must publish an “official statement” disclosing key offering information.
Characteristics of Municipal Bonds
The most notable feature of municipal bonds is their tax treatment. In the United States, most municipal bonds are tax-exempt, which is particularly attractive to investors in high-tax brackets. Because interest income from municipal bonds is generally not included in federal income taxes, these bonds have certain advantages for wealthy investors.
Although municipal bonds generally have lower coupons than corporate bonds, high-tax investors can still compare these bonds fairly to other investments subject to income taxes by calculating the taxable equivalent return. The higher an investor's tax rate, the more attractive the tax-free interest offered by municipal bonds.
For example, if an investor with a 38% tax rate receives a 1.0% tax-free return on a municipal bond, the taxable equivalent return would be 1.6%.
However, municipal bonds are generally less liquid, meaning they are not traded as actively as corporate bonds. The higher minimum investment, typically $5,000, also makes these bonds less liquid. In addition, municipal bonds have a relatively low risk of default, largely because many are backed by tax revenues from state and local governments.
Even so, the market still faces some challenges. For example, there is growing concern about the potential for local government defaults as property values fall sharply. To reduce investor risk, many investors consider choosing municipal bond insurance to ensure that even if the issuer is unable to make timely interest and principal payments, the insurance company will still make payments.
In many countries, including the United Kingdom and Canada, there are also issuers of municipal bonds, which facilitate the financing of local governments. The specific issuance mechanisms and characteristics of municipal bonds vary according to the laws of different countries and regions.
The appeal of municipal bonds is clear, especially for investors in high-tax environments. However, as the market evolves and local government economies develop, will these bonds remain attractive?
