Municipal bonds are securities issued by cities, counties, states and other governmental entities to finance projects that are considered beneficial to the public good. Likely projects are: housing, schools, highways, hospitals, sewer systems and other infrastructure.
Municipal bonds are appealing to some investors because their interest income is typically exempt from federal taxation and, in most cases, from state and local taxes, if the investor resides in the state of issuance.1 This tax advantage may provide investors in high tax brackets with a greater after-tax return than an investment in taxable securities with higher nominal yields.2
You can compare the yield a taxable investment would have to earn to the tax exempt return offered by a municipal bond. This formula is known as the taxable equivalent yield (TEY), and Morgan Stanley provides an online calculator to help you evaluate taxable and tax exempt bonds.3
To Use the TEY Calculator:
- Enter Your Tax Free Yield
- Select your tax bracket and the state in which you live
- Press Calculate
- General obligation (GO) bonds and revenue bonds are the two most common categories of municipal securities. There are two types of GO bonds: unlimited tax and limited tax. The principal and interest payments of an unlimited tax GO bond are backed by the full faith, credit and taxing power of the issuer. Should the borrower default, ad valorem (property) taxes can be levied without limit or amount to satisfy debt service. Limited tax GO bond interest payments are restricted to a specific revenue stream or amount within a tax, and there may be no pledge to raise taxes if there is a revenue shortfall.
- Revenue bonds, in contrast to GOs, make interest and principal payments solely from the revenue generated by the funded project; for example, bridges, toll roads, electric power plants and wastewater treatment facilities.
- Prerefunded municipal bonds are created when municipalities issue new securities to refinance outstanding debt that was issued at a higher rate. Once the refinancing is completed, the issuer uses the proceeds to purchase US Treasury securities, which are placed in an escrow account. The proceeds from the escrow account are then used to pay interest and principal on the original debt until the issue is called or matures.
- Taxable municipal bonds represent a small segment of the municipal bond market that is not tax exempt. They are issued to finance projects that don't provide a significant benefit to the general public. Bonds issued to finance local sports facilities or underfunded public pensions are examples of federally taxable municipal securities. Depending on credit quality, taxable municipal bonds may offer returns comparable to taxable securities, such as corporate bonds, and may be suitable for retirement accounts.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.