an investor holds another type of
municipal bond, the chances of being
paid in full on his or her investment
can vary, depending on the reliability
of the source of funds pledged to make
interest and principal payments.
General Obligation Bonds. General
obligation bonds are voter-authorized
long-term debt instruments. The issuer
of GO bonds promises to levy taxes
as necessary to make full and timely
payments to investors. Historically,
these bonds have been one of the safest
investments available and, as a result,
have tended to pay lower rates of interest.
Taxable Municipal Bonds. A driving
incentive for people to invest in
municipal bonds is that the income
derived from them is not taxable.
But just as not all municipal bonds
are GO bonds, not all of them
generate tax-free income either.
Returns on some municipal bonds are
taxable because the federal government
regards the projects financed by their
proceeds as not providing significant
benefit to the general public. Bonds
tend to be more volatile than other
bonds that pay interest regularly.
Municipal Notes. Municipal notes
are short-term debt obligations that
usually mature within a year or less,
but may sometimes be issued for as
much as three years. Municipalities
use these notes to stabilize cash flow
while they wait to receive expected
revenue. Stated differently, these
short-term debt securities allow public
agencies to fund temporary cash
While many people mistakenly
believe that all municipal bonds are
GO bonds, this type of bond actually
makes up only roughly one-third
of the municipal bond market. The
remaining two-thirds is comprised of
revenue bonds, which are not backed
by taxes, but instead rely on specific
revenue streams for their repayment.
Just as not all municipal
bonds are GO bonds,
not all of them generate
tax-free income either.
Governmental bodies have not been
immune to revenue shortfalls caused by
turbulent financial climate of the past
few years. In addition, most states do
not permit any sort of deficit spending.
As a result, doubts have arisen as to
whether states such as California, Illinois,
Pennsylvania, and a number of others
will be able to satisfy outstanding GO
bond obligations. Therefore, the rates of
return for such instruments have been
increasing, and GO bonds are currently
delivering attractive after-tax yields.
issued to finance projects such
as stadiums, replenishment of a
municipality’s underfunded pension
plan, or investor-led housing are a
few examples of issues that would not
qualify for a federal tax exemption.
deficits caused by the cyclical nature of
tax and other receipts. These types of
municipal notes are tied to the source
of future cash flow and include tax
anticipation notes, revenue anticipation
notes, and bond anticipation notes.
Revenue Bonds. Principal and
interest payments for revenue bonds
are secured by the income stream
generated by the particular project
being financed. In some cases revenue
bonds are backed by sales taxes, fuel
taxes, or hotel occupancy taxes.
Insured Bonds. Some municipal bonds
are insured under policies written by
commercial insurance companies.
The insurance policy is intended to
provide for the insurer to pay principal
and interest payment to bondholders in
the event the issuer defaults. However,
investors should take into account the
creditworthiness of both the insurer
and the issuer when considering
whether to purchase insured bonds.
Build America Bonds are a recent
category of taxable municipal bonds
introduced in the wake of the 2008
financial crisis. Designed to reduce the
cost of borrowing for states, municipal
governments, and other governmental
agencies, the bonds provide the issuer
with a 35 percent federal rebate on
interest costs. Build America Bonds only
subsidize an issuer’s borrowing costs;
they do not provide guaranties or other
backing from the U.S. government.
Zero-Coupon Bonds. Zero-coupon
bonds are issued at an original issue
discount and the full value, including
accrued interest, is not paid until the
bonds mature. Interest income may
be reportable annually, even though
no annual payments are made.
Market prices of zero-coupon bonds
Housing Bonds. Housing bonds are
debt instruments secured by mortgages
and mortgage loan payment streams.
These bonds can be called at any time
because of the prepayment of principal
on the underlying mortgages, although
this is not reflected in the call feature. It
is this issue that led to collateralized debt
obligations (CDOs) and certain aspects
of the 2008 financial crisis. Michael
Lewis has a terrific explanation of these
products in his book, The Big Short.
Matt Taibbi also explains these products
quite colorfully in his book Griftopia.
Conduit Bonds. This type of bond
is issued by a state agency called a
“conduit issuer” that is a third party that
acts on behalf of the actual borrower,
typically a private non-profit 501(c)( 3)
continued on page 28