You can lose money on municipal bonds

Municipal Bond Explains: Use and Tax Exemption [for Beginners]

Last updated & checked: 29.10.2020

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The municipal bond is a bond that is issued by various institutions, but also by a city, a certain municipality, government agency and / or the American state. In addition, a municipal bond can be issued by a school authority or, for example, through public infrastructure projects. Within the American financial market, a municipal bond is also linked to tax-free municipal bonds. In Europe, the market for municipal bonds is mainly dominated by authorities and supranational organizations such as the World Bank, the Reconstruction Loan Corporation (KfW) and the European Investment Bank (EIB). The European and worldwide countries are increasingly merging into one market: municipal bonds are therefore increasingly popular.

Different types of issuance

A municipal bond can be issued in the following different ways:

  • General Obligation

  • Revenue Obligation

In the case of general obligations, there is security through the tax revenue of a specific tax area; in the case of revenue obligations, the income is secured, for example, through projects. Often times, a recipient of interest income from municipal bonds is exempt from federal taxes and taxes in the state that the bonds are issued. In some cases, a municipal bond may be taxed. A municipal bond enables an investor to generate tax-free interest income. The interest that an investor receives is often exempt from state taxes. The special regulations for the respective country must be observed.

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Special tax status

The special tax status of municipal bonds leads investors to low yields. The issue is also of interest for the financing of public welfare, because the interest rate that has to be paid in the open market of municipal bonds is usually lower than with other loan financing. It is possible that a tax authority approaches market participants and requests them to repay incorrectly received tax breaks. There is also no specific licensing process for the tax status and the regulations are structured in a complex manner. This creates the risk that municipal bonds, which were previously tax-exempt, are no longer tax-exempt later. Another risk is bankruptcy because, for example, US cities are highly indebted. In the case of municipal bonds, a market participant must always take into account whether a debtor is solvent. It should also be determined whether the liquidity of a local government, for example, will change in the future, and whether it will even improve. These considerations should also include innovations and numerous other social contexts and events in which trends for the market economy can be identified. It is of great importance for market participants to obtain complete information about the given market conditions, including the respective legal regulations and the advantages and disadvantages of the respective financial trading, so that there are no nasty surprises and serious, existential losses that a market participant may not can compensate for more. If the liquidity of a municipality has expired and high taxes are levied, then it is possible that the creditors lose almost their entire investment in sync with this bankruptcy. In the event of bankruptcy, an insolvency plan is drawn up to restore the budget.

Advantages and Disadvantages of Municipal Bonds

The biggest advantage of municipal bonds is the generation of tax-exempt interest income. The market for municipal bonds is relatively small. Because such investments are often kept in the portfolio until the end of the term, fewer positions reach the financial market. This makes pricing difficult. The positions reflect different projects. Numerous factors are of great importance for determining the price of the positions. A larger bid / ask spread is therefore expected.

In the case of municipal bonds, the debtor is under public law. For this reason, too, municipal bonds are often very popular. However, careless budgetary policies or structural changes can lead municipalities, for example, to over-indebtedness. In most countries, municipalities are not subject to bankruptcy law. This prevents them from filing for bankruptcy or getting into bankruptcy proceedings. If the debt interest payments exceed the income of the municipalities, there is a risk of payment being deferred for an indefinite period of time. In addition, it can be ordered to waive any claims. Municipal bonds are structured by a number of national and regional regulations in Europe. In addition, municipal bonds can have tax implications. Before investing in municipal bonds, it is very important to read up on business magazines, books, banks, brokers and tax authorities, for example about tax legislation.

Market participants must also be careful not to be persuaded by brokers into risky deals with municipal bonds and should not invest all of their savings, because in the past this has made market participants bitterly regret their decision to buy municipal bonds, such as in the case of UBS. It is also taken into account which economic characteristics a respective local government has, for example, and whether the municipal bonds will consequently be profitable in the future. In addition, numerous disadvantages, including for investors, can arise if, for example, cities go bankrupt. This produces poverty and a lack of creative power, which moreover remain hidden at first glance. But if, for example, facilities such as indoor swimming pools are closed, a city's indebtedness becomes apparent, even if other parts have been renovated beforehand. For example, there is such a debt problem for many German cities in Germany.

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The tax exemption

The tax exemption depends on where you pay taxes and where the emission is legally assigned. A tax-exempt bond can be very interesting in a US state, for example, for a market participant in a city that does not belong to this state, there may be no high or no tax exemption at all. In addition, the yield of such securities can be very interesting for market participants.

The Use of Municipal Bonds

If, for example, a municipality needs funds to finance the construction of a public building or the budget, then in addition to the possibility of borrowing, the issue of a municipal loan is also considered. With the help of a municipal bond, a municipality borrows funds and undertakes to repay it through a promise of debt. It is also possible to list on the stock exchange. Municipal bonds are rather unknown in Germany and are rarely used for financing - in the USA, municipal bonds, so-called munibonds, are a very popular and frequently used financing instrument. Over the past 40 years, municipal bonds have become an important means of public funding in the United States. Financial markets do not exist and develop independently of one another, but are in a global context. In the USA, as in Europe, municipal bonds are issued by states, counties, cities and other government agencies. Municipal bonds are used, for example, to finance the budget. In addition, specific projects are often funded. Below are some examples of the areas in which such projects are funded:

  • University projects

  • public buildings

  • Infrastructure: roads, highways, bridges and airports

In addition, electricity power plants and renewable energies, for example, are subsidized.

Zero-bond character from Municipal Bonds

The tax peculiarities of municipal zero bonds are very attractive for US investors due to the profit opportunities. German investors are not interested in this because municipal zero bonds have lower pre-tax returns. In the event of early termination, the obligee receives the interest. As a result, investors lose many of the advantages of zero bonds. Municipal zero bonds are therefore not suitable for interest rate immunization, for securing the portfolio against changes in interest rates or for speculation.

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Municipal Zero-Bond Convertible Notes

The municipal zero bond convertible bonds represent a connection between a zero bond convertible bond and a municipal zero bond. After a savings phase of several years, these bonds are converted into a coupon bond. The zero bond contained therein enables exempt interest income. The risk of termination does not apply to these convertible bonds.

Transparency at Municipal Bond's

In the case of optimal trading in municipal bonds, sufficient information is made available in advance, because the municipalities, and often citizens who may have to pay taxes, rely on thinking constructively. For market participants or citizens, it is necessary to have knowledge of the respective implementation of municipal bonds. A higher degree of transparency enables a higher accumulation of knowledge. The more information there is about a financial market, the more transparent it is. Optimal market transparency is characterized by the fact that all market participants have complete information about all traded goods, their price, quality and other conditions, such as location or delivery. Regular quality reports from a company also serve to increase market transparency.

Increasing volume of municipal bonds

As a prerequisite for a municipal bond, investors must first build trust in a functioning joint liability system. The interest in municipal bonds in Germany is growing steadily. Interest in municipal bonds is growing, especially in the context of the current legislative period, which affects the shaping of Germany's future. It also makes predictions about what the future of bonds might look like, and poses numerous new questions in response to societal problems in order to solve the problems. Questions arise, for example, about the climate, charitable projects, education or living space. With regard to municipal bonds, particular attention is paid to the advantages and disadvantages. Quick surveys, for example, can provide clues for answers. Municipalities in particular, which assume that the conditions for borrowing will deteriorate, expect bonds to become more important for municipal financing in the future (79% according to a survey by KfW). A worsening of the borrowing conditions for municipal loans is often expressed by a limited number of provider banks. As borrowing conditions deteriorate, a municipal bond becomes more attractive to the issuer. The volume of municipal bonds in Germany will rise steadily in the future. The municipalities are also dependent on new investors. Investors are often looking for safe investments. However, bonds will not replace credit to a large extent in the future, because they are not an attractive investment, especially for numerous, small and medium-sized municipalities due to their disadvantages. The following components have an impact on the municipal lending business:

  • regulatory changes
  • Sovereign debt crisis
  • changed risk assessment of municipalities by banks

In the future, municipal bonds will form a further component in a series of municipal financing instruments in addition to loans. In the long term, far-reaching reforms of the municipal finance system and the federal financial structure are sought by federalism reform commissions. The increase in numbers and volumes of municipal market participants who issue bonds is associated with changes in the structure and functions of government units below the state level. Re-examining and restructuring sources of revenue for municipal units and access to finance for new infrastructures are important issues in Europe. The European Union continues to grow and determine which categories of municipal borrowing are included in the national debt limit and which are not. Although the issuance of bonds by state governments in Europe is more likely than that by municipal units, the participation of municipal units in the bond markets is increasing significantly. This happens in part because of the state's need to fund day-to-day government processes and because of infrastructure investments in roads, hospitals, bridges, water storage basins and other infrastructures, while state governments have debt limits. State and municipal bond markets therefore coexist as distinct markets and serve as independent sources of funding for both state and local governments. The municipal bond market in Europe is experiencing less individual investor participation than that in the US. US retail investors in municipal bonds enjoy significant tax breaks on their investments. However, there are certain countries in Europe, such as Germany, where numerous market participants are increasingly inclined to participate in the municipal bond market.

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Innovative form of financing

Municipal bonds are also a way of promoting innovative forms of finance to meet local and regional needs. The first bond issue in Europe, which was developed in Germany in accordance with Islamic principles, was a municipal bond called Sukuk. It did not offer interest payments, but instead paid investors a return equivalent to the EURIBOR interest rate. Some areas of activity in the economy are not under the direct responsibility of the state government, but the government must and wants to develop and strengthen the functioning of these areas. A few areas that the government is focusing on in this regard are listed below:

  • Mortgage loans to secure affordable real estate

  • Student loans for educational purposes

  • Loans to farms or medium-sized companies

To finance these expenses, a state government can set up an agency and finance that agency by issuing bonds. These bonds are guaranteed by the government, known as agency bonds, and can be either government or privately held. For example, the German government guarantees bonds that are issued by the Kreditanstalt für Wiederaufbau (KfW). KfW offers real estate and small business loans. The US government is using a mixed strategy, guaranteeing some mortgage-backed and other unsecured bonds. Market participants who issue municipal bonds are rated by credit agencies according to criteria with regard to creditworthiness and creditworthiness. Some municipal bonds are sometimes rated as high as the top-rated government bonds, but not always because the underlying characteristics of the issuer are unlikely to be identical. Innovative forms of financing also go hand in hand with technical, social and economic change.

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