Types of Municipal Securities

Municipal securities can be categorized in a number of ways. Basic distinctions can be made based on the maturity date and redemption provisions described below.

Municipal bonds are generally used by issuers for long-term financing of capital projects. Maturity dates are typically between one and 30 years from issuance. Interest may be paid either at a stated fixed rate, or at a variable rate that is determined from time to time based on a stated process or formula. Bonds that pay interest only at maturity (typically compounded) are called zero coupon or capital appreciation bonds.

• Serial Bonds
  In the municipal securities market, it is common for issuers to employ serial bonds to structure their debt. This financing technique involves the issuance of a number of different bonds that mature in consecutive years in one issue. Structuring the bonds in this way allows the issuer to repay principal over time and to make payments of principal that match revenue expectations over that time period. Although part of the same issue, each serial bond is a different security for purposes of sales and trading.
• Term Bonds
  A bond with a single maturity that comprises the entire issue is sometimes called a term issue. If a large part of a serial bond issue is comprised of identical bonds with a single maturity date, the bonds with that maturity is called the term maturity. In such issues, the term maturity normally will have a maturity date later than the last maturity of all of the serial bonds.
• Callable-Bonds
  Municipal bonds and other municipal securities often contain provisions giving the issuer the option to redeem or call specific bonds prior to the stated maturity date. A specified minimum amount of notice, generally 30 days, is provided to bond holders if the issuer elects to exercise its call rights. Call provisions sometimes require an issuer exercising an optional call to pay a premium for early redemption (e.g., 103% of par value paid on principal redeemed). The provisions governing such premiums normally require lower premiums as the bonds approach maturity date. Call provisions may differ among bonds that are part of the same issue. For example, in an issue containing serial bonds, only those bonds with maturities over ten years from the issuance date may be subject to optional call.
   
  Other types of early redemption provisions are also common in municipal bonds, depending to a large extent on the type of bond. These include sinking fund provisions that allow the issuer to retire principal amounts of debt at a designated rate and provisions requiring early redemption of principal under specified circumstances (e.g., a change in the revenue stream backing a bond). These provisions (or, in some cases, optional calls by the issuer) may result in the partial redemption of bonds in a specific maturity. Call provisions for the bond, described in the official statement, will specify how specific securities are chosen to be redeemed (e.g., by lottery).

The term municipal note is used for securities that mature in a shorter period of time than a bond, often within a year or less. Notes may be structured by the issuer to make periodic interest payments or to pay interest only at maturity. Notes often are categorized by the purpose of issuance. These categories include: (i) Tax Anticipation Notes (TANs) issued to obtain funding in advance of tax collections during the upcoming year; (ii) Revenue Anticipation Notes (RANs) issued in anticipation of specified revenue; and (iii) Bond Anticipation Notes (BANs) which provide short-term funding for capital projects that ultimately will be financed with long-term bonds.

Several different types of municipal securities pay variable interest rates. The most common type is a variable rate demand obligation or VRDO. The interest rate for VRDOs typically is reset at short intervals (e.g., daily or weekly). VRDO holders have the right to tender or put back their securities to the issuer’s designee in return for face value. This ability is normally backed by a liquidity agreement provided by a commercial bank. Interest rates are reset based on a process in which the securities are continuously re-marketed to investors and new interest rates are set. Most VRDOs have a long-term maturity date (e.g., 30 years) and are callable by the issuer. However, similar variable-rate structures also exist for notes having relatively short-term maturities.

Some variable-rate municipal securities reset interest rates based on a formula linked with an external interest rate index such as the London Inter-Bank Offering Rate (LIBOR). These are much less common in the municipal securities market than are VRDOs. One additional example of a municipal security that pays interest at a variable rate is the auction rate security. Auction rate securities use an auction process to reset interest rates for short-term periods but do not provide liquidity guarantees to holders seeking to sell securities at the periodic auctions. The market for auction rate securities experienced an extreme dislocation beginning in early 2008 and continued to be largely illiquid. Few, if any, auction rate securities have been issued since that time.

Features of Municipal Securities

Payment of principal and interest on a municipal security may be backed by various types of pledges and forms of security. Below is a general description of some of the more common principal and interest payment features. For detailed information about a specific bond, refer to its official statement, available on EMMA.

The term general obligation is used to describe a debt security in which the full faith, credit and taxing power of the issuer is pledged to pay principal and interest. General obligation bonds issued by local governments typically include a pledge to use the issuer’s ad valorem taxing power to pay principal and interest. Ad valorem taxes necessary to pay debt service on general obligation bonds are often not subject to state constitutional property tax millage limits (an unlimited tax bond). The term limited tax is used when such limits exist.

General obligation bonds constitute debts of the issuer and often require approval by election prior to issuance. In the event of default in required payments of interest or principal, the holders of general obligation bonds have certain rights to compel a tax levy or a legislative appropriation (as might be the case for a general obligation bond issued by a state).

Revenue bond is the term used generally to describe a bond that is not backed with a general obligation from an issuer with taxing authority. The issuer of a revenue bond is not obligated to pay principal and interest on its bonds using any source other than the source(s) specifically pledged in the bond. If the specified source(s) of revenue become inadequate, a default in payment of interest or principal may occur. Various types of pledges of revenue may be used to secure interest and principal payments on revenue bonds. The nature of these pledges may differ widely based on the type of issuer, type of revenue stream, and other factors.

Some revenue bonds are issued by governmental agencies to fund facilities for essential public services. A bond issue by a municipal water and sewer authority, for example, typically would involve revenues obtained through local water and sewer assessments. The pledge of revenue would identify specific assessments that can be used to pay principal and interest on the bonds, the authority’s responsibility and ability (if any) to raise water and sewer assessments, and any superior claim on the assessments, for example.

Another type of revenue bond may be issued by a governmental issuer acting as conduit for the benefit of a private sector entity. In these cases, the governmental issuer is seeking to advance specific public purposes within its mission, with such conduit bonds commonly issued for not-for-profit hospitals, single and multi-family housing, airports, solid waste disposal facilities, student loan programs, and redevelopment programs. Principal and interest on such bonds normally are paid exclusively from revenues pledged by the entity receiving financing (the obligor). Unless otherwise specified under the terms of the bonds, the issuer is not required to make payments of principal or interest if the obligor defaults.

A relatively small percentage of municipal securities embody both general obligation and revenue pledges. The term double-barreled bond is used for these securities.

Some municipal securities are backed by a third-party credit enhancement which backstops the primary pledge to pay principal and interest. Bond insurance is one form of credit enhancement. Another form of credit enhancement is a letter of credit issued by a bank, which can be drawn on to make payments on the bonds if the primary source of pledged revenue is inadequate. Investors should take care to note the current credit quality of the insurer or letter of credit bank as well as the credit of the issuer or the obligor.

Insured bonds and bonds backed by letters of credit often carry two separate ratings, one of which is based on the financial strength of the insurer or bank and the other underlying rating is based on the financial strength of the issuer or obligor making the primary pledge for payment of principal and interest. In other cases, a guarantee may be provided by a different type of related third party, such as another unit of government or, in the case of private activity bonds, a parent corporation or other entity related to the private beneficiary of the bonds.

A distinguishing characteristic of most municipal securities is that the interest paid on the securities is exempt from federal income tax. Municipal bonds often are referred to simply as tax-exempt bonds. For interest on a municipal security to be exempt from the investor’s gross income for federal income tax purposes, the issuer must meet a number of requirements in the federal income tax code and regulations. The official statement for new issues of municipal securities generally includes a statement on the cover and other detailed information with respect to the tax-exempt status of the issue. The official statement also typically includes the opinion of a bond counsel addressing, among other things, the federal income tax exemption.

In some cases, interest on a municipal security is not tax-exempt. Some taxable municipal securities are issued under special programs such as the Build America Bonds program adopted as part of the American Recovery and Reinvestment Act of 2009. Taxable municipal securities can also be issued if the purpose of the issuer’s financing does not meet certain public purpose or public use tests under the federal tax rules.

In addition, a bond initially issued as a tax-exempt bond can become a taxable bond if the issuer fails to comply with certain federal tax law requirements.

Some municipal securities pay interest that is exempt from gross income under the ordinary federal income tax calculation but are nonetheless subject to the federal alternative minimum tax, or AMT. In that case, some of the benefits of tax-exemption may be lost for taxpayers who are subject to the AMT. The official statement for such an issue normally will state that the securities are subject to the AMT.

A state may provide an exemption from state income tax for interest on municipal securities in certain cases. Specific provisions and conditions of such exemption vary from state to state and not all states provide an exemption. In many states, investments by state residents in securities issued by the state or any other municipal issuer within the state will be provided with an exemption, but not for investments in out-of-state bonds.

For more information, see Section 103 of the Internal Revenue Code of 1986. Various other sections of the Internal Revenue Code also affect the tax treatment of municipal securities for federal income tax purposes and should be consulted.