Fixed Income Municipal

Fixed Income — Municipal

Core Concepts

General Obligation (GO) Bonds

Backed by the full faith, credit, and taxing power of the issuing municipality. The issuer pledges to use any available revenue source (property tax, income tax, sales tax) to repay bondholders. GO bonds typically require voter approval and are considered safer due to the broad taxing pledge.

Revenue Bonds

Backed solely by the revenue generated from a specific project or source — toll roads (toll collections), water/sewer systems (utility fees), hospitals (patient revenue), airports (landing fees, terminal rents). Revenue bonds typically carry higher yields than GO bonds of comparable maturity and credit quality because of the narrower revenue pledge.

Tax-Equivalent Yield (TEY)

The core calculation for comparing municipal bonds to taxable alternatives:

Federal only: TEY = Muni Yield / (1 - federal_marginal_rate)

Federal + state (for in-state munis): TEY = Muni Yield / (1 - federal_rate - state_rate × (1 - federal_rate))

This converts a tax-exempt yield to the pre-tax yield a taxable bond would need to offer to match the muni's after-tax income.

Note: the state_rate × (1 - federal_rate) term assumes state income tax is fully deductible against federal tax. For taxpayers at or above the SALT deduction cap (or taking the standard deduction), state tax provides no incremental federal deduction, and the formula simplifies to TEY = Muni Yield / (1 - federal_rate - state_rate) — the combined formula above understates the in-state muni's advantage for capped itemizers and overstates the precision of the comparison generally. Check the client's actual SALT position before choosing the formula.

Alternative Minimum Tax (AMT)

Certain private activity bonds generate interest that is subject to AMT. For taxpayers subject to AMT, the tax advantage of these bonds is reduced. AMT-subject bonds typically trade at slightly higher yields to compensate. Non-AMT munis (governmental purpose bonds) are not affected.

Muni Credit Analysis

GO bonds: evaluate tax base diversity and trends, debt burden ratios (debt per capita, debt/assessed value), fund balance as % of expenditures, economic base (population, employment), pension/OPEB obligations.

Revenue bonds: evaluate debt service coverage ratio (DSCR = net revenue / annual debt service), rate covenants, additional bonds tests, demand analysis, and reserve fund adequacy.

De Minimis Tax Rule

Discount bonds purchased below a threshold (typically par minus 0.25% per year to maturity) may lose tax-exempt status on the discount portion — the gain is taxed as ordinary income rather than being tax-exempt. This affects the after-tax return calculation for discount munis.

Muni Yield Ratios

Muni yield / Treasury yield. Historically this ratio averages approximately 80% for AAA munis. Ratios above 80-85% suggest munis are cheap relative to Treasuries; below 70% suggests they are rich. The ratio varies with supply/demand, tax policy expectations, and credit conditions.

Build America Bonds (BABs)

Taxable municipal bonds created under the 2009 stimulus. The federal government subsidizes 35% of interest cost. Expired for new issuance after 2010 but outstanding BABs continue to trade. They allowed issuers to access the broader taxable bond market.

Pre-Refunded/Escrowed Bonds

When an issuer advance-refunds a callable bond, it places US Treasuries in escrow sufficient to pay remaining coupons and the call price. These defeased bonds are effectively AAA-quality and trade at very tight spreads.

Key Formulas