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Municipal Bonds. 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. What Is a “Muni”?.

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Municipal Bonds

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Municipal Bonds

A Brief Explanation

By Rob French


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“Public goods are those which are in everybody’s interest to have, but in no one’s interest to provide.”

-The Economist, April 23rd


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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.


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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


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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.


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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!


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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


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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.


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GO Bonds (continued)

  • The issuer can employ any means available to guarantee payments.

    • Sell property

    • Raise taxes


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GO Bonds (continued)

  • Projects funded by GO bonds generally do not produce revenue.

    • Building or remodeling of schools

    • Roads (not toll roads)

    • Bridges


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Revenue Bonds

  • Repaid by the money the project earns from tolls, fees, bills, tickets, or other services.

    • Housing developments

    • Hospitals

    • Convention centers

    • Sports stadiums


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“Double Barrel” Bonds

  • Municipal bonds that are both general obligation bonds and revenue bonds.

    • Drinking water

    • Wastewater treatment

    • Toll roads


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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.


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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.


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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.


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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


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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.


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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).


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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.


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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.


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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…)


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