Aside from the specific set of issuers—state and local governments—the defining characteristic of municipal bonds is their tax status. The interest income earned on most municipal bonds is exempt from federal income taxes. Interest payments are also generally exempt from state taxes if the owner of the bond resides within the state that issued the security, and the same rule applies to local taxes.
The two main types of municipal bonds are general obligation bonds (G.O.s) and revenue bonds. G.O.s are municipal bonds secured by the full faith and credit of the issuer and usually supported by the issuer’s taxing power. Revenue bonds are secured by the charges tied to the use of the facilities financed by the bonds. For example, revenue bonds are issued to fund toll roads, bridges and water treatment facilities, among other projects, and are secured by the tolls or fees collected by these facilities.
About $2.3 trillion in municipal bonds are outstanding, sold by more than 60,000 issuers, according to the Federal Reserve.
Munis May Offer Attractive After-Tax Returns, High Credit Quality
In part because of their unique tax status, municipals may generally provide investors with greater after-tax returns than many taxable bonds, including some Treasuries and corporate bonds with similar credit quality and maturities. The following chart compares yields for triple-A rated munis, triple-A rated industrial bonds and U.S. Treasury bonds of similar maturity as of December 31, 2006.
Municipal debt is also typically of high credit quality. More than 99% of rated municipal bonds carry investment-grade ratings from Moody’s Investors Service. Well over half of rated munis are single-A and above. In addition, the 10-year cumulative default rate on municipal bonds was only 0.04% between 1970 and 2000, according to a November 2002 report from Moody’s. By comparison, the 10-year default rate for corporate bonds over the same time period was 9.83%, Moody’s reported.
Many municipal bonds are backed by insurance, in addition to the credit of the municipality or the revenues from the project being funded. If an insured municipal bond defaults, an insurance company should step in and make all principal and interest payments on the bond.
Volatility Tends to be Lower on Munis
Historically, returns on municipal bonds tend to be less volatile than those on other asset classes, from equities to long-term Treasuries, as shown in the chart below.
One reason for the lower volatility: individuals are the main investors in the municipal bond market and in general do not actively trade the bonds. Retail investors tend to buy and hold muni bonds to maturity. This contrasts with many other fixed-income sectors where institutional investors dominate.
Individuals comprise more than 70% of the municipal bond investor base. In the chart below, individuals account for households, mutual funds, bank trust departments, closed end funds, and money market funds. Property and casualty insurance companies are the next largest set of investors at around 14%. The remaining investors are banks and corporations. Some institutions are crossover, or arbitrage, investors who buy munis when they are particularly attractive versus other fixed-income asset classes.
Conclusion
Municipal bonds are issued by or on behalf of state and local governments to finance general operations or specific projects. Interest payments on most muni bonds are exempt from federal taxes, and when the investor resides in the issuer’s state and locality, interest payments may also be exempt from state and local taxes.
In addition to their tax-exempt status, muni bonds may offer several advantages, including: higher after-tax returns than many other taxable bonds, high credit quality, and relatively low volatility. While institutional investors dominate the investor base in most fixed income sectors, retail investors form the biggest investor base in the municipal bond market.