Fixed Income Types: Municipal Bonds

Municipal Bonds: Tax-Exempt Financing and Market Dynamics

Municipal bonds play a crucial role in financing infrastructure projects, public facilities, and other governmental initiatives at the state and local levels. They offer investors the opportunity to earn tax-exempt income while supporting essential public services. In this section, we will explore the detailed aspects of municipal bonds, including their tax-exempt nature, various types, derivative securities, tax risks, yield spreads, primary and secondary markets, and accessibility for individual and institutional investors.

Introduction

Types of Tax-Exempt Municipal Bonds

Municipal bonds can be classified into different types based on the purpose of issuance and the revenue streams used for repayment.

General Obligation (GO) Bonds

General obligation bonds are backed by the full faith, credit, and taxing power of the issuing municipality. They are typically used to finance public projects that benefit the entire community, such as schools, parks, and infrastructure. GO bonds are considered the most secure type of municipal bonds.

Example: The city of Gainesville issues general obligation bonds to fund the construction of a new public library. The bonds are secured by the city's taxing authority and repayment is supported by property taxes.

Revenue Bonds

Revenue bonds are backed by specific revenue streams generated from the projects they finance. These bonds are issued to fund revenue-generating facilities like toll roads, airports, water utilities, and sports stadiums. The repayment of revenue bonds depends on the revenue generated by the specific project.

Example: The Orlando International Airport issues revenue bonds to finance the construction of a new terminal. The bonds' repayment is supported by the airport's revenue, including landing fees, passenger facility charges, and concession fees.

Special Tax Bonds

Special tax bonds are secured by specific taxes imposed by the issuing municipality, such as sales taxes, hotel taxes, or special assessments. These bonds are often used to finance specific projects or initiatives that directly benefit the revenue source.

Example: The city of Miami issues special tax bonds backed by a portion of the local sales tax revenue to finance the construction of a new convention center. The bonds' repayment is supported by the sales tax revenue generated within the designated area.

Municipal Derivative Securities

Municipal derivative securities are financial instruments derived from municipal bonds. They provide investors with additional strategies for managing interest rate risk. Two common types of municipal derivatives are:

Municipal Swaps

Municipal swaps involve the exchange of fixed or variable interest rate payments between parties. These swaps allow municipalities to manage their debt portfolio's interest rate exposure by converting variable rate debt to fixed rate or vice versa.

Example: A municipality with variable rate bonds enters into a swap agreement with a counterparty to convert its variable rate payments to fixed rate payments. This helps stabilize its debt service costs.

Municipal Options

Municipal options give investors the right, but not the obligation, to buy or sell municipal securities at a predetermined price within a specific time frame. These options provide investors with flexibility to manage their portfolio risks or take advantage of market movements.

Example: An investor holds municipal bonds and purchases a put option, giving them the right to sell the bonds at a predetermined price. If the bond's market value declines, the put option provides downside protection.

Municipal Inverse Floaters Creation

Inverse floaters are a type of municipal derivative security that has a variable interest rate inversely tied to a benchmark interest rate. They are created through a process called "residual interest financing." In this process, the issuer creates two separate bonds: one with a fixed interest rate and the other with an inverse floating rate. The income from the fixed rate bond covers the interest payments on the inverse floater.

Example: A municipality creates inverse floaters by issuing two bonds: a fixed rate bond and an inverse floater linked to LIBOR (London Interbank Offered Rate). As LIBOR increases, the interest rate on the inverse floater decreases, resulting in lower interest payments for the issuer.

Tax Risks

Investors in municipal bonds face tax risks related to changes in tax laws and regulations. There are two key tax risks:

Legislative and Regulatory Risk

Changes in tax laws and regulations can impact the tax-exempt status of municipal bond interest. If tax laws are amended, the tax-exempt status of future interest payments on municipal bonds may be affected, potentially leading to a decrease in the bonds' market value.

Alternative Minimum Tax (AMT) Risk

Certain types of municipal bonds, known as private activity bonds, may be subject to the alternative minimum tax (AMT) for individual taxpayers. AMT limits the tax-exempt benefits of these bonds for some investors.

Yield Spreads in the Municipal Market

Yield spreads in the municipal market refer to the difference in yields between municipal bonds and other comparable fixed-income securities, such as U.S. Treasury bonds. Several factors influence yield spreads, including credit quality, tax advantages, liquidity, supply and demand dynamics, and prevailing market conditions.

Primary and Secondary Markets

Municipal bonds are traded in both primary and secondary markets:

Primary Market

The primary market is where new issuances of municipal bonds are sold to investors. Issuers may use underwriters, such as investment banks, to facilitate the issuance process. Institutional investors, such as mutual funds and insurance companies, typically participate in the primary market.

Secondary Market

The secondary market involves the trading of already-issued municipal bonds among investors. Broker-dealers, banks, and electronic platforms facilitate secondary market transactions. Both individual and institutional investors can access the secondary market to buy or sell municipal bonds.

Accessing the Primary and Secondary Markets

Individual and institutional investors can access the primary and secondary markets in the following ways:

Individual Investors

Individual investors can access the primary market by purchasing new issuances directly from their brokerage accounts or participating in bond offerings through their financial advisors. In the secondary market, individual investors can buy and sell municipal bonds through brokerage firms or online trading platforms.

Institutional Investors

Institutional investors, such as mutual funds, insurance companies, and pension funds, can participate in the primary market by purchasing bonds directly from underwriters or through negotiated sales. In the secondary market, institutional investors have access to bond brokers, dealers, and electronic trading platforms to buy or sell municipal bonds.

Conclusion

Municipal bonds provide investors with tax-exempt income while enabling state and local governments to finance essential public projects. Understanding the various types of tax-exempt municipal bonds, derivative securities, tax risks, yield spreads, and the primary and secondary markets is essential for investors and market participants. Whether accessing the market as an individual or institutional investor, a comprehensive understanding of municipal bonds empowers participants to make informed investment decisions and contribute to the growth and development of communities.

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.