Municipal Bonds Explained: GO vs Revenue Bonds, Tax Exemption and the Real Risks

When a city builds a school, a state widens a highway or a water authority replaces old pipes, the money often comes from municipal bonds. For investors, "munis" are best known for interest that is often free of federal income tax. That benefit has conditions, and municipal bonds carry real risks. This explainer draws on the Municipal Securities Rulemaking Board (MSRB), the self-regulatory organisation that writes rules for the municipal market and runs its official disclosure website, EMMA.

What a municipal bond is

The MSRB defines municipal bonds as "debt obligations that states, cities, counties and other public entities issue to finance infrastructure projects such as building schools, highways and sewer systems, as well as to fund the issuer's day-to-day obligations." Buying one means lending money to the issuer in exchange for regular interest payments and the return of the bond's par value at maturity.

Investors can buy individual bonds directly or through separately managed accounts, or own them indirectly through mutual funds and ETFs that hold municipal debt.

The two main types

• General obligation (GO) bonds are backed by the issuer's "full faith and credit." The issuer has the power to tax residents to pay bondholders.
• Revenue bonds are repaid from the revenue of a specific project or system, such as toll roads, bridges, airports, electric and water utilities, colleges or hospitals. If the project earns less than expected, bondholders are exposed.

A special case is private activity bonds (conduit bonds). A public entity issues them on behalf of a private borrower, for example a hospital, affordable-housing developer or college, that cannot issue tax-exempt debt itself. The MSRB stresses that the public issuer "does not take responsibility to pay or guarantee the payment." The private borrower, called the obligor, is the one on the hook.

Most munis pay a fixed rate. A minority pay variable rates, most commonly variable rate demand obligations (VRDOs). These are long-term securities whose rates reset periodically, and they are mostly bought by institutions.

The tax exemption, with conditions

Interest on many municipal bonds "is excluded from gross income for federal income tax purposes and, in some cases, is also exempt from state and local income taxes." Because of that, tax-exempt munis typically pay lower interest rates than taxable bonds such as corporates "and even Treasury bonds."

The MSRB lists important exceptions:

• Not all munis are tax-exempt. Issuers sometimes sell taxable municipal bonds when a project fails federal purpose or public-use tests.
• State tax exemption usually depends on residence. To avoid state and local tax, "the buyer generally must be a resident of the state where the bond was issued, although there are exceptions."
• AMT bonds. Some bonds, including certain private activity bonds, are subject to the federal alternative minimum tax. They usually yield a bit more to compensate.

Comparing a muni with a taxable bond

A common way to compare is the taxable-equivalent yield: the tax-free yield divided by (1 minus your marginal tax rate). A muni yielding 3% for an investor in a 32% federal bracket is roughly equivalent to a taxable yield of 3 ÷ 0.68, or about 4.4%. If state tax also applies to the alternative, the muni's advantage grows. For an investor in a low bracket it shrinks, which is why munis mostly make sense in higher tax brackets and in taxable accounts. Holding tax-exempt bonds in an IRA wastes the exemption.

Features to read before buying

• Par value. Usually expressed in multiples of $1,000. Fixed-rate munis are typically sold in minimum denominations of $5,000.
• Coupon. Typically paid semiannually.
• Maturity. Often one to 30 years. Serial bonds come as a set maturing year after year. Term bonds mature on one date, usually after 20 years or more.
• Price. Quoted as a percentage of par: at par (100), at a premium (above 100) or at a discount (below 100).
• Call provision. Many munis can be redeemed early by the issuer, though usually not before a set period such as 10 years.
• Yield to worst. The lowest yield you could get, allowing for early redemption. The MSRB notes this is the yield that must be shown on your trade confirmation. For a bond bought at a premium it is often the yield to call.

The risks

The MSRB is blunt: munis "are often considered a safe investment; however, the return of principal and interest is not guaranteed," and some, such as high-yield munis, "may be risky." The main risks:

1. Credit or default risk. The issuer or obligor may be unable to pay. Check the source of repayment, any bond insurance or other credit support, and the issuer's financial disclosures.
2. Interest rate risk. When market rates rise, existing bond prices fall, and longer maturities are more sensitive. Hold to maturity and you get par back, assuming the issuer pays. Sell early and you may get more or less than you paid.
3. Call risk. Issuers tend to call bonds when rates fall so they can refinance more cheaply. That ends your stream of interest just when reinvesting is least attractive.
4. Reinvestment risk. The proceeds from a matured or called bond may only be reinvestable at lower rates.
5. Liquidity risk. Many munis trade rarely. The MSRB says liquidity risk is generally greater for lower-rated bonds, small issues, recently downgraded bonds and infrequent issuers. Selling quickly can cost money.

Credit ratings and EMMA

Many munis carry ratings from agencies such as S&P, Moody's, Fitch or KBRA. The MSRB reminds investors that ratings "represent the opinion of the rating agency and not a statement of fact," and that they can change.

The best free research tool is the MSRB's EMMA (Electronic Municipal Market Access) website, emma.msrb.org, the official repository of municipal market data and disclosure documents. On EMMA you can read a bond's official statement, its offering document; its continuing disclosures, the annual financial information and event notices that issuers must keep providing; and its recent trade prices. Checking recent trades helps you judge whether a price you are quoted is reasonable.

Bottom line

Municipal bonds let investors lend to state and local governments, often with tax-free interest. Know whether a bond is GO or revenue-backed, whether its interest is actually exempt for you (federally, in your state, and under the AMT), whether it can be called, and how easy it will be to sell. Then compare its taxable-equivalent yield with other options and look it up on EMMA before buying.

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