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Basics of Taxable Municipal Bonds

Historical Perspectives

  • Municipal bond market is the primary credit market for state and local governments in the US. While many investors seek out muni debt for its tax-advantaged status, there is a growing interest in the taxable segment of the muni market
  • Tax Reform Act of 1986 (TRA): TRA created more certain rules as to who specifically could use or issue tax-exempt debt; the legislation introduced additional limitations and tests on Private Activity Bond (PAB) issuance; the more stringent rules thereafter regarding what was eligible tax-exempt issuance caused the taxable market to significantly increase; while 1985 saw only $260mn of taxable munis issued, that number rose to $3.4bn in 1986; from 1987 to 2007, taxable muni issuance grew at an average annual rate of 14.5%
  • Build America Bonds program (BABs): Following the financial crisis, government enacted a stimulus package that introduced the BAB program; though the program expired at the end of 2010, 24.6% of total municipal issuance that year was taxable muni bonds; the major significance of BABs is how they introduced a new class of participants to the muni market; BABs’ primary investors are institutional investors, such as pension funds and insurance companies; taxable mutual funds also entered the BAB market

Overview of the Market

  • The IRS classifies muni bonds as either governmental or non-governmental
  • Governmental bonds are sold to finance activities that are owned and operated by a state or local government; governmental bonds are also referred to as essential purpose bonds and are normally tax-exempt bonds
  • Non-governmental bonds are also called private activity bonds (PABs) and only some of these are tax-exempt
  • General Obligation Bonds: GOs are supported by the taxing power of the issuer; in the event that the issuer of the GO fails to pay the bondholders as agreed, the trustee has the right to sue in court to compel the issuer to increase taxes in order to meet the obligation
  • Revenue Bonds: payments from revenue bonds come from the earnings of a project; should the revenue prove inadequate to meet the debt service on the bond, the state is not obliged to pay
  • Pre-refunding: issuers can pre-refund some bonds when yields decline; in a pre-refunding, a municipality would issue a new bond at a lower market rate, and use the proceeds from the new bond to purchase Treasury securities whose maturity and amounts match the first call date and the coupon payment dates on the existing, higher rate issue; the holder of the existing issue would then have a security that would be called at the next call date, with payments backed by securities held in the escrow account; however, the Tax Cuts and Jobs Act repealed the tax-exemption on advance refunded bonds issued after 12/31/17 – all but eliminating advance refunding going forward

Taxable Muni Market Structure Differences

  • Maturity: Compared to corporate bonds, taxable munis have much longer maturities; 70% of TXMB index members have a maturity after 2028
  • Creditworthiness: Munis are generally of higher credit quality than corporate bonds, whether taxable or not
  • Municipal defaults (few and far between): Munis historically trumps corporates when it comes to defaults; higher-rated munis rarely default (Moody’s study over the period between 1970 and 2016 found only 103 defaults of Moody’s-rated muni issuers, or a 0.07% default rate); even Baa-rated bonds only had a 0.4% average cumulative default rate
  • Historical performance: reviewing the past 5 years, taxable municipal bonds’ OAS has been roughly the same as high grade corporate’s OAS, but wider than tax-exempt munis

Build America Bonds (BABs)

  • Congress authorized a special type of munis under the American Recovery and Reinvestment Act
  • Intended to provide qualified municipal borrowers subsidized funding for infrastructure spending along with other essential municipal purposes
  • Unlike most munis, the interest income is fully taxable at the federal level for investors but generally not by the state
  • For direct-pay BABs, the tax benefit goes to the issuers, who receive a subsidy from the federal government of 35% of the coupon payment
  • However, as a result of the government-wide sequester, the 35% subsidy mentioned above was reduced by 7.2% in 2014, 7.3% in 2015, 6.8% in 2016, and 6.9% in 2017
  • Similar to other taxable munis, BABs have long maturities; 91.5% of the total par amount of BABs issued had a maturity at issuance greater than 10 years; of those bonds, almost 70% had a maturity greater than 20 years
  • If we weight the ratings distribution for TXMB for BABs and non-BABs, we can see that the weighted ratings average for the BAB index members was a Moody’s/S&P rating of Aa2/AA, one notch higher than the non-BAB taxable munis’ average rating of Aa3/AA-

Bank of America Merrill Lynch: Primer on Taxable Muni Bonds, May 2018

Image Source: Federal Reserve Board Flow of Funds data, BAML Research

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