Municipal bonds: who pays, how it matures, and when it is taxed

Whose promise is it?

A general obligation bond is backed by the issuer’s taxing power and a revenue bond by the earnings of a project. There is a third arrangement that looks municipal and is not. A private activity bond is a revenue bond a municipal issuer sells on behalf of a private entity that cannot issue tax-exempt debt on its own, to finance things like healthcare facilities, affordable housing and educational facilities.

In that arrangement the public entity is a conduit issuer. It lends its name and its access to the tax-exempt market, and it does not take responsibility to pay or guarantee the bonds. The private borrower — the obligor — is the one who pays the interest and returns the principal. A candidate who reads the city’s name on the bond and concludes the city is behind it has made the mistake the structure invites. Some revenue bonds are also non-recourse: if payments stop, bondholders have no claim on the underlying revenue source or against the conduit borrower, and when a conduit borrower fails to pay the issuer, the issuer is usually not required to pay the bondholders.

That is also where the tax answer stops being simple. Municipal interest is often excluded from federal income tax and sometimes from state and local income tax as well, but "often" is doing work in that sentence. Interest is free of state and local tax only where the buyer is generally a resident of the state that issued the bond, subject to exceptions: the SEC notes that the interest may also be exempt if the bond was issued by a US territory, such as Puerto Rico. Some municipal bonds are taxable outright, because the purpose of the financing does not meet the purpose or public use tests in the federal tax rules. And certain municipal bonds, private activity bonds among them, are subject to the federal alternative minimum tax, so the interest can be pulled into an investor’s AMT calculation even though it is exempt from the regular tax. Two more tax points. The exemption covers interest, not gains: a profit on selling a tax-exempt municipal bond can be federally taxable. And to compare a municipal bond with a taxable one, convert its yield: tax-equivalent yield = tax-exempt yield ÷ (1 − the investor’s tax rate). For an investor whose rate is 24%, a 4% municipal yield equals 4% ÷ 0.76 = 5.26% from a taxable bond. The higher the tax rate, the more the exemption is worth.

The last piece is how the debt is shaped. A serial issue is a group of bonds with a series of maturity dates, typically one each year for up to twenty years, so the issuer retires the borrowing gradually. A term issue comes due in a single maturity, typically after twenty years, and the issuer may agree to pay into a sinking fund for mandatory redemption before maturity or for payment at maturity. Fixed-rate municipal bonds are typically sold in denominations that are multiples of $5,000, not the $1,000 par familiar from corporate bonds.

Exam terms

Private activity bond

A revenue bond issued for a private borrower, whose interest may be an AMT preference item.

Conduit issuer

The public entity that issues the bond without responsibility to pay or guarantee it.

Obligor

The private borrower who actually pays the interest and principal.

Serial bond

A group of bonds with a series of maturity dates, typically one a year.

Term bond

A single maturity, often with a sinking fund behind it.

Sinking fund

Periodic payments set aside for mandatory redemption or for payment at maturity.

Tax-equivalent yield

Tax-exempt yield ÷ (1 − tax rate): the taxable yield that would leave the same after tax.

Worked example

An investor in one state is offered a tax-exempt bond issued by another state on behalf of a private, for-profit company, and asks how the interest will be taxed.

1. Start federally. Municipal interest is generally excluded from federal income tax, so the regular federal answer is exempt.
2. Now the alternative minimum tax. This is a private activity bond, so the interest can be an item of tax preference and may be included in the investor’s AMT calculation.
3. Now the state. The bond was issued by another state, so the investor is generally not a resident of the issuing state and the interest is usually taxable at home.
4. And a separate question about credit, which the tax answer does not touch: the issuing state is a conduit and does not guarantee the bonds. The company is the obligor.
5. So the honest answer is federally exempt, possibly caught by the AMT, probably taxable by the investor’s own state, and backed by a company rather than by a government.

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Related practice

• Issuer type and repayment sourcePractice this