Municipal Bonds A Brief Explanation By Rob French A Brief Explanation By Rob French

“Public goods are those which are in everybody’s interest to have, but in no one’s interest to provide.” -The Economist, April 23rd “Public goods are those which are in everybody’s interest to have, but in no one’s interest to provide.” -The Economist, April 23rd

What Is a “Muni”? Municipal bonds are instruments of debt issued by civic entities such as states, cities, and counties that are used by the local or state government to temporarily fund short-term operating expenses, permanently fund long-term capital expenditures, and fund specific projects.

Original Function Historically used to finance services, projects, and infrastructures that benefit the public directly. –Schools –Bridges –Roads –Sewer –Water facilities –Fire districts –Airports –Port authorities Historically used to finance services, projects, and infrastructures that benefit the public directly. –Schools –Bridges –Roads –Sewer –Water facilities –Fire districts –Airports –Port authorities

Additional Function Tax-exempt securities are frequently used for non-traditional purposes that primarily benefit non-governmental organizations and individuals. –Commercial and industrial businesses –Residential home mortgages –Housing developments –Hospitals –Convention centers –Sports stadiums –Industrial pollution abatement programs. Tax-exempt securities are frequently used for non-traditional purposes that primarily benefit non-governmental organizations and individuals. –Commercial and industrial businesses –Residential home mortgages –Housing developments –Hospitals –Convention centers –Sports stadiums –Industrial pollution abatement programs.

Read My Lips…No Taxes Although the tax reform act of 1996 created classes of bonds that are subject to federal income tax, most municipal bonds are still TAX FREE!

Types of “Munis” Although there are many types, municipal bonds are generally classified according to the source from which the issuer intends to reimburse bond payments. –GO bonds –Revenue bonds –“Double Barrel” bonds Although there are many types, municipal bonds are generally classified according to the source from which the issuer intends to reimburse bond payments. –GO bonds –Revenue bonds –“Double Barrel” bonds

GO Bonds General Obligation bonds or “GO bonds” are unsecured bonds that are backed by the "the full faith and credit" of the local or state government that issued the bond.

GO Bonds (continued) The issuer can employ any means available to guarantee payments. –Sell property –Raise taxes The issuer can employ any means available to guarantee payments. –Sell property –Raise taxes

GO Bonds (continued) Projects funded by GO bonds generally do not produce revenue. –Building or remodeling of schools –Roads (not toll roads) –Bridges Projects funded by GO bonds generally do not produce revenue. –Building or remodeling of schools –Roads (not toll roads) –Bridges

Revenue Bonds Repaid by the money the project earns from tolls, fees, bills, tickets, or other services. –Housing developments –Hospitals –Convention centers –Sports stadiums Repaid by the money the project earns from tolls, fees, bills, tickets, or other services. –Housing developments –Hospitals –Convention centers –Sports stadiums

“Double Barrel” Bonds Municipal bonds that are both general obligation bonds and revenue bonds. –Drinking water –Wastewater treatment –Toll roads Municipal bonds that are both general obligation bonds and revenue bonds. –Drinking water –Wastewater treatment –Toll roads

Appropriate Uses The state of Oregon relies on specific factors to justify issuing debt. –To distribute the expenses for a project to the individuals that will benefit from the project over its useful life rather than requiring today’s taxpayers to pay for future use. –In times of inflation, future reimbursement of the debt is assisted by the fact that the money used to repay the debt at maturity will not be as valuable. The state of Oregon relies on specific factors to justify issuing debt. –To distribute the expenses for a project to the individuals that will benefit from the project over its useful life rather than requiring today’s taxpayers to pay for future use. –In times of inflation, future reimbursement of the debt is assisted by the fact that the money used to repay the debt at maturity will not be as valuable.

Appropriate Uses (cont.) The state of Oregon relies on specific factors to justify issuing debt. –To help purchase needed equipment or improve a facility to become more liquid. –With extra available cash, general fund revenues can be used for operating expenses and other less expensive needs. The state of Oregon relies on specific factors to justify issuing debt. –To help purchase needed equipment or improve a facility to become more liquid. –With extra available cash, general fund revenues can be used for operating expenses and other less expensive needs.

Investment Risk Typically considered to be safe, as it is unlikely that the government will declare bankruptcy. Some recent exceptions include Washington State and California. Not a lot of information available regarding individual municipal bonds. Typically considered to be safe, as it is unlikely that the government will declare bankruptcy. Some recent exceptions include Washington State and California. Not a lot of information available regarding individual municipal bonds.

Bond Ratings Credit ratings help investors appraise the risk and reward of the bond. There is a direct correlation between the risk and the reward of the bond. Moody’s, Standard and Poors, and Fitch offer independent ratings based on a range of factors that include –Current debt –Liquidity –Finances –Management decisions Credit ratings help investors appraise the risk and reward of the bond. There is a direct correlation between the risk and the reward of the bond. Moody’s, Standard and Poors, and Fitch offer independent ratings based on a range of factors that include –Current debt –Liquidity –Finances –Management decisions

Bonds For the Wealthy Municipal bonds are most advantageous for individuals that are in the highest tax brackets. If you pay little or no taxes, you could make more money with other bonds or investments with similar risk. Municipal bonds are most advantageous for individuals that are in the highest tax brackets. If you pay little or no taxes, you could make more money with other bonds or investments with similar risk.

Tax vs. no Tax To compare untaxed municipal bonds to taxable corporate bonds, divide the tax-exempt yield by one minus the tax bracket of the investor. Tax exempt yield/(1-tax bracket)=tax equivalent yield). To compare untaxed municipal bonds to taxable corporate bonds, divide the tax-exempt yield by one minus the tax bracket of the investor. Tax exempt yield/(1-tax bracket)=tax equivalent yield).

Tax vs. no Tax -cont. An investor that pays 10 percent tax and is looking to buy a 20-year municipal bond with a yield of 4.51 earns the same as a taxable bond with a 5.01 percent yield (.0451/(1-.10)=.0501). Could make more money by buying a regularly taxed corporate bond with a similar risk. An investor that pays 10 percent tax and is looking to buy a 20-year municipal bond with a yield of 4.51 earns the same as a taxable bond with a 5.01 percent yield (.0451/(1-.10)=.0501). Could make more money by buying a regularly taxed corporate bond with a similar risk.

Tax vs. no Tax -cont. If the investor pays 35 percent tax, the same municipal bond now has a tax equivalent yield of 6.94 percent (.0451/(1-.35)=0.0694). May be a better rate. If the investor pays 35 percent tax, the same municipal bond now has a tax equivalent yield of 6.94 percent (.0451/(1-.35)=0.0694). May be a better rate.

Is It Fair That the Wealthy Benefit the Most? Civic entities need funds and cannot compete well with commercial companies without the tax free advantage. If civic entities were denied the ability to issue tax-free bonds, all of the projects now funded in this way would be more expensive (smaller schools, dirt roads…) Civic entities need funds and cannot compete well with commercial companies without the tax free advantage. If civic entities were denied the ability to issue tax-free bonds, all of the projects now funded in this way would be more expensive (smaller schools, dirt roads…)