We learned about the securities issued by the central government of a country (such as US Treasury). Along with that the local and state governments also issue bonds, known as municipal bonds (or municipal securities).
- In the U.S., there is a large market for municipal bonds.
- Though there are both tax-exempt and taxable municipal bonds, most bonds are tax-exempt. Here, tax exemption is for the interest earned from the bond, nor for the capital gains.
- Just like other bonds, investors in municipal bonds also face credit risk and liquidity risk.
- The bonds are traded over-the-counter in dealers market.
Types of Municipal Bonds
Municipal bonds can be broadly classified into three types, namely, tax-backed debt, revenue bonds, and special bonds. Let’s look at each of them.
- These are debt obligations issued by states, counties, districts, schools, etc. and are backed by tax revenue. There are many types of tax-backed debt such as General Obligation Debt, Appropriation-backed Debt, Obligation supported by credit enhancement programs.
- General Obligation Debt: This could be limited or unlimited obligation debt, as the issuer may have unlimited taxation power. The tax source could be income tax, corporate tax, sales tax, or property tax. In limited tax debt, the issuer is limited by how much tax it can levy to service the debt. Some bonds may be secured by tax revenue plus certain fees and grants (Double-barrelled in security)
- Appropriation-backed Obligation: These bonds are also called moral obligation bonds and are issued by some states. The key feature is that is these bonds default the state’s legislature can make an appropriation of funds from the state’s pledged general tax revenue. It is, however, legally not obligated to do so as in the case of general obligation debt.
- Debt obligation supported by public credit enhancement programs
- Revenue bonds are issued to finance projects or enterprises.
- The revenue from the project or the enterprise being financed is pledged to service the debt.
- The details and rules for revenue disbursement can be different and are set forth in a trust indenture.
- Special bonds can have features of both tax-backed bonds and revenue bonds.
- Examples are insured bonds and prerefunded bonds.
- The insured bonds, apart from being secured by the issuer’s revenue, are also backed by an insurance policy underwritten by an insurance company. This reduces credit risk for the investors.
- Municipals are sometimes prerefunded and hence the bonds are called prerefunded bonds. This happens when the original bonds are escrowed or collateralized by direct obligations guaranteed by the U.S. government. In case of prerefunded bonds, the bonds are structured such that the refunded bonds are to be called at the first possible call date or a subsequent call date.