The Debt Markets (part D)
by
Charles Lamson
Municipal Bonds & Government Agency Securities
Municipal Bonds
Municipal Bonds (munis) are bonds issued by state, county, or local governments to finance public projects such as schools, utilities, roads, and transportation ventures. The interest on municipal securities is exempt from federal taxes as well as from state taxes for investors living in the issuing state. This allows for the issuer to borrow at a lower rate than if taxes would have to be paid on the interest earned.
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Taxpayers in a tax bracket higher than the average marginal bracket can earn a higher return by investing in munis. The cost to the state, county or local government issuer is less than it would be if the interest income were not tax exempt. Thus, if the comparable corporate rate is 8 percent, the average marginal tax bracket is 25 percent and the muni rate is 6 percent. Taxpayers in a tax bracket above 25 percent can earn a higher after-tax return by investing in munis. In addition, in this case, municipalities can borrow at a 2 percent lower rate than if their interest income were not tax exempt.
Municipal bonds may be either general obligation bonds or revenue bonds. General obligation bonds are repaid out of general tax revenues. There has not been a default in the state-issued municipal bonds market in the last 100 years. This is not true for munis issued by local and county governments. Repayment of revenue bonds is tied to the success of a specific project that the bonds support. That is, the bondholder is paid back out of the cash flows of a particular project. There have been defaults on revenue bonds when specific projects did not generate the forecasted revenues.
Government Agency Securities
Government agency securities are issued by private enterprises that were publicly chartered by Congress to reduce the cost of borrowing to certain sectors of the economy. Government agency securities may be divided into two classes: government-sponsored enterprises and federally-related-institutions securities markets.
Areas where government-sponsored enterprises (GSEs) have been established include housing, farming, the savings and loan industry, and student loans. Among others, GSEs include the Federal Home Loan Banks, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Farm Credit System, and the Student Loan Marketing Association. All are privately owned and issue long-term securities (bonds) to assist in some aspect of lending, such as funding of mortgage loans, student loans and farm credit. In most cases, the federal government has no legal obligation to guarantee the timely payment of interest and principal. However, many market participants assume that the government does de facto guarantee the payments.
In addition to government agency securities, the Federal Financing Bank, created in 1973, issues bonds to borrow for several federally related institutions. Among others, these institutions include the Commodity Credit Corporation, the General Services Administration, the Government National Mortgage Association, the Rural Telephone Bank, the Small Business Administration, and the Tennessee Valley Authority. The bonds issued by the Federal Financing Bank are backed by the full faith and credit of the U.S. government.
The yield spread between government agency securities and U.S. government securities reflects differences in liquidity and risk. The yield can be significant because secondary markets do not have the breadth and depth of Treasuries.
Recap
Municipal securities are bonds issued by state, county, and local governments. The interest income on municipal securities is exempt from federal taxes and from state income taxes for investors in the state where the municipals were issued. Municipal securities may be either general obligation bonds or revenue bonds. Government agency securities are issued by government-sponsored enterprises and by the Federal Financing Bank.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 412-413*
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