Municipal securities can be categorized in a number of ways. Basic distinctions can be made based on the tax status, coupon type, maturity date, and redemption provisions described below.
Tax-Status
A distinguishing characteristic of most municipal securities is that the interest paid on the securities is exempt from federal income tax. Municipal bonds often are referred to simply as tax-exempt bonds, although not all tax-exempt bonds are municipal securities. For interest on a municipal security to be exempt from the investor's gross income for federal income tax purposes, the issuer must meet a number of requirements in the federal income tax code and regulations. The official statement for new issues of municipal securities generally includes a statement on the cover and other detailed information with respect to the tax-exempt status of the issue. The official statement also typically includes the opinion of a law firm, usually referred to as “bond counsel,” addressing, among other things, the federal income tax exemption.
In some cases, interest on a municipal security is not tax-exempt. Some taxable municipal securities are issued under special programs such as the Build America Bonds program adopted as part of the American Recovery and Reinvestment Act of 2009. Taxable municipal securities can also be issued if the purpose of the issuer’s financing does not meet certain public purpose or public use tests under the federal tax rules.
In addition, a bond initially issued as a tax-exempt bond can become a taxable bond if the issuer fails to comply with certain federal tax law requirements, which can have significant adverse consequences to owners of such bonds.
AMT Bonds
Some municipal securities pay interest that is exempt from gross income under the ordinary federal income tax calculation but are nonetheless subject to the federal alternative minimum tax, or AMT. In that case, some of the benefits of tax-exemption may not be available to taxpayers who are subject to the AMT. The official statement for such an issue normally will state that the securities are subject to the AMT.
State Tax Treatment
A state may provide an exemption from state income tax for interest on municipal securities in certain cases. Specific provisions and conditions of such exemption vary from state to state and not all states provide an exemption. In many states, investments by state residents in securities issued by the state or any other municipal issuer within the state will be provided with an exemption, but not for investments in out-of-state bonds.
Serial Bonds
In the municipal securities market, it is common for issuers to employ serial bonds to structure their debt. This financing technique involves the issuance of a number of different bonds that mature in consecutive years in one issue. Structuring the bonds in this way allows the issuer to repay principal over time and to make payments of principal that match revenue expectations over that time period. Although part of the same issue, each serial bond is a different security for purposes of sales and trading.
Term Bonds
A bond with a single maturity that comprises the entire issue is sometimes called a term issue. If a large part of a serial bond issue is comprised of identical bonds with a single maturity date, the bonds with that maturity are called term bonds or a term maturity. In such issues, the term maturity normally will have a maturity date later than the last maturity of all of the serial bonds.
Callable Bonds
Municipal bonds and other municipal securities often contain provisions giving the issuer the option to redeem or call specific bonds prior to the stated maturity date. A specified minimum amount of notice, generally 30 days, is provided to bond holders if the issuer elects to exercise its call rights. Call provisions sometimes require an issuer exercising an optional call to pay a premium for early redemption (e.g., 101% of par value paid on principal redeemed). The provisions governing such premiums normally provide for lower premiums as the bonds approach maturity date. Call provisions may differ among bonds that are part of the same issue. For example, in an issue containing serial bonds, only those bonds with maturities over ten years from the issuance date may be subject to optional call.
Other types of early redemption provisions are also common in municipal bonds, depending to a large extent on the type of bond. These include sinking fund provisions that allow the issuer to retire principal amounts of debt in specific amounts and provisions requiring early redemption of principal under specified circumstances (e.g., a change in the revenue stream backing a bond). These provisions (or, in some cases, optional calls by the issuer) may result in the partial redemption of bonds in a specific maturity. Call provisions for the bond, described in the official statement, will specify how specific securities are chosen to be redeemed (e.g., by lottery).
Credit Enhancements
Some municipal securities are backed by a third-party credit enhancement which backstops the primary pledge to pay principal and interest. Forms of credit enhancement include bond insurance, bank letters of credit, state school guarantees, and credit programs of federal or state governments or federal agencies. Credit enhancement serves as a secondary source of payment if the primary source of payment is insufficient. Investors should take care to note the current credit quality of the guaranty or letter of credit bank but should also consider carefully the credit of the issuer or the obligor since the financial strength of credit enhancers can change over time and in some cases could decline.
Insured bonds and bonds backed by letters of credit often carry two separate ratings, one of which is based on the financial strength of the insurer or bank and the other underlying rating is based on the financial strength of the issuer or obligor making the primary pledge for payment of principal and interest. In other cases, a guarantee may be provided by a different type of related third party, such as another unit of government or, in the case of private activity bonds, a parent corporation or other entity related to the private beneficiary of the bonds.
Original Issue Premium
Original issue premium refers to the amount by which the public offering price of a security at the time of its original issuance exceeded its par value. The original issue premium is amortized over the life of the security and results in an adjustment to the basis of the security. Original issue premium generally is not deductible for federal income tax purposes. The amount of original issue premium received by the issuer in a primary offering, also known as the “bond premium,” is generally treated as proceeds of the issue.
Original Issue Discount
Original issue discount refers to an amount by which the par value of a security exceeded its public offering price at the time of its original issuance. The original issue discount is amortized over the life of the security and, on a municipal security, is generally treated as tax-exempt interest. When the investor sells the security before maturity, any profit realized on such sale is calculated (for tax purposes) on the adjusted book value, which is calculated for each year the security is outstanding by adding the accretion value to the original offering price. The amount of the accretion value (and the existence and total amount of original issue discount) is determined in accordance with the provisions of the Internal Revenue Code and the rules and regulations of the Internal Revenue Service.
Capital Appreciation Bonds
A capital appreciation bond (CAB) is a municipal security on which the investment return on an initial principal amount is reinvested at a stated compounded rate until maturity, at which time the investor receives a single payment (the “maturity value”) representing both the initial principal amount and the total investment return. CABs typically are sold at a deeply discounted price with maturity values in multiples of $5,000. CABs are distinct from traditional zero coupon bonds because the investment return is considered to be in the form of compounded interest rather than accreted original issue discount.
Zero Coupon Bond
Zero coupon bonds are a type of original issue discount bond on which no periodic interest payments are made but which is issued at a deep discount from par, accreting (at the rate represented by the offering yield at issuance) to its full value at maturity.
Variable Rate Securities
Several different types of municipal securities pay variable interest rates. The most common types are variable rate demand obligations (VRDOs) and auction rate securities (ARS). The interest rate for VRDOs typically is reset at short intervals (e.g., daily or weekly). VRDO holders have the right to tender or put back their securities to the issuer’s designee in return for face value. VRDOs are long-term securities (e.g., maturity date of 30 years) with short-term interest rate periods. Interest rates are reset periodically through programs operated by dealers, called remarketing agents, on behalf of the issuers of the securities. The interest rate is set to allow the securities to be sold at par, although trades in VRDOs outside of the “put” feature described below are not guaranteed to occur at par. VRDOs typically have a high minimum denomination requiring a minimum investment of $100,000. Current interest rate information for VRDOs can be found on EMMA at: http://emma.msrb.org/MarketActivity/RecentVRDO.aspx.
A distinguishing characteristic of VRDOs is the existence of a “put” or “tender” feature that allows a holder to liquidate a position, at par, on a periodic basis. VRDOs are structured to pay investors, should they tender their securities and the remarketing agent does not resell or otherwise purchase the securities, through a “liquidity facility,” typically provided by a bank. This is done through one of two basic forms: (i) with use of a letter of credit from the bank, which provides both a guarantee of liquidity and a guarantee that principal and interest will be paid for the life of the letter of credit; or (ii) with a stand-by bond purchase agreement, in which the bank does not undertake the guarantee that principal and interest will be paid, but provides only that tendered securities will be purchased so long as the stand-by bond purchase agreement remains in effect.
Auction rate securities use an auction process to reset interest rates for short-term periods but do not provide liquidity guarantees to holders seeking to sell securities at the periodic auctions. ARS are long term securities that have variable interest rates that reset on a short-term basis. The typical auction process is one referred to as a Dutch auction. At each auction, investors have the option to hold, sell, or buy additional securities at par. If there are a sufficient number of purchase bids to match the offered sales on the terms indicated in the bids and offers, the auction will succeed and the interest rate for the next rate period will be set at the lowest "clearing" rate necessary to achieve such matching. Otherwise, the auction will fail, current owners of the securities will retain their ownership, and the interest rate for the next rate period will be set at the "fail" rate, which typically is a relatively high rate. If no current owners of the securities wish to sell at an auction, they will retain ownership and the interest rate for the next rate period will be set at the "all-hold" rate, which typically is a relatively low rate. Auctions are conducted by agents of the issuer of the auction rate security, called auction agents, and orders are submitted to the auction agent by certain dealers, called program dealers, that have rights granted to them through an agreement with the issuer to submit orders. Trades in ARS outside of the auction procedure described above are not guaranteed to occur at par.
“All hold” rates often are linked to a market index and generally are intended to be lower than a clearing rate. Maximum rates can be a specific fixed interest rate or linked to a market index. The market for auction rate securities experienced an extreme dislocation beginning in early 2008 and continues to be largely illiquid, although a limited number of ARS continue to receive purchase bids and appear to experience successful auctions. Current information for ARS can be found on EMMA at http://emma.msrb.org/MarketActivity/RecentARS.aspx.
Other less common forms of municipal securities that pay variable interest rates include, but are not limited to, securities whose rate is set by formula, usually based on an independent index rate such as LIBOR (London Interbank Offered Rate) or other market index. In addition, commercial paper, which typically matures within 270 days or less of maturity and can be refinanced or “rolled-over” with additional newly issued commercial paper, has many, but not all, of the same characteristics of variable rate securities.
Additional Information
For more information, see Section 103 of the Internal Revenue Code of 1986. Various other sections of the Internal Revenue Code also affect the tax treatment of municipal securities for federal income tax purposes and should be consulted.
To read about sources of security for payment of principal and interest on municipal bonds, see the Types of Municipal Securities section.