Municipal Securities

Ever wonder how your city is able to fund large projects? A new bike trail, a public school, an airport, or even a football stadium? It all comes down to municipal securities.

Municiapl securities are bonds issued by state and local governments, like cities or counties. The municipality sells off bonds to get immediate access to money. To repay that, the government can use either taxation authority or use the asset itself to pay back the bondholders, General Obligation Bonds and Revenue Bonds respectively.

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Episode Four Transcript

Hey everyone, welcome back to the FINRA Ninja Podcast, where we simplify complex financial topics to help you crush the SIE exam! I’m your host, Sean, and today, we’re diving into a topic that not only appears on your exam but directly impacts your community: Municipal Securities. You might hear people talk about “munis” from time to time, but what exactly are they? How do they work? And more importantly, why should you care about them?

By the end of this episode, you’ll have a solid understanding of how municipal bonds help fund public projects like schools, roads, and even airports. We’ll cover the different types of municipal bonds, their risks, benefits, and the process of issuing these bonds. So, whether you’re studying for the SIE or just curious about how your city funds its projects, stick around!

Alright, let’s kick things off with the basics. What are municipal securities?

Simply put, municipal securities, or munis, are bonds issued by state and local governments to raise money for public projects. These can include everything from improving roads and building schools to constructing toll bridges and funding public parks. In short, munis help fund the infrastructure and services that make our communities function. And unlike corporate bonds, these are issued by governments rather than businesses.

Now, why do cities and states sell these bonds in the first place? Well, they often don’t have the cash upfront to finance large projects. By selling municipal securities to investors, governments get the funds they need now in exchange for repaying the bondholders over time, typically with interest. In return, investors get a relatively safe income stream, often with a significant tax benefit. But more on that later.

Now, if you’re thinking, “Great, but what’s in it for me as an investor?” Well, here’s the key benefit: Municipal bonds are often exempt from federal taxes! And if you live in the state or city that issued the bond, you might even be exempt from state and local taxes, too. It’s like a mini tax break, courtesy of your local government. So, for investors, this tax advantage makes municipal bonds particularly attractive, especially for those in higher tax brackets.

General Obligation (GO) Bonds

Let’s start by breaking down one of the most common types of municipal bonds: General Obligation Bonds, or GO bonds. These bonds are essentially a promise from the government to repay the borrowed money using its general taxing power. They’re used to fund projects that don’t directly generate revenue, like public schools, parks, or roads. So, how does the government pay back these bonds if the projects themselves don’t bring in any cash?

Here’s where property taxes come into play. When a city issues a GO bond, it’s essentially saying, “We’ll pay you back with tax money.” Property taxes, also known as ad valorem taxes (which means “according to value” in Latin), are the most common source of repayment. Homeowners in a given area pay property taxes based on the assessed value of their property, and that money goes toward repaying the bondholders.

One important note here is that GO bonds are unsecured. They’re not backed by any specific asset or collateral, unlike a mortgage or a car loan. Instead, they’re backed by the full faith and credit of the issuing government, which essentially means, “We’ll tax our citizens if we have to.” While this may sound risky, municipal issuers typically have a strong credit rating—often higher than corporations—making GO bonds relatively safe.

But, and this is important, defaults can still happen. Let’s take a trip down memory lane to 2013, when Detroit declared bankruptcy and defaulted on about $20 billion in debt. The causes? Decades of declining population, rising expenses, and a shrinking tax base. Detroit wasn’t alone either—Puerto Rico has seen significant defaults in recent years due to financial struggles and natural disasters. Even though defaults are rare, they’re not impossible.

If a city is teetering on the edge of default, one option is to raise taxes. But here’s the catch: in most cases, voters have to approve those tax hikes, and, let’s be honest, convincing people to pay more taxes isn’t easy. Plus, sometimes raising taxes won’t solve the problem—take the 2018 Camp Fire in California. Many residents left the area, property values plummeted, and raising taxes couldn’t make up for the loss.

So, while GO bonds are generally safe, it’s still important to assess the financial health of the issuing municipality before investing.

Revenue Bonds

Next up, let’s talk about Revenue Bonds. These are a bit different from GO bonds in that they’re repaid using the income generated by the project they’re funding. Think toll roads, airports, water systems—things that actually bring in money. In this case, the bondholder gets paid back from the revenue stream, not from taxes.

For example, let’s say your city wants to build a toll road. They issue a revenue bond, and the tolls collected from the drivers using that road are used to pay back the bondholders. It sounds straightforward, right? Well, here’s the catch: revenue bonds are riskier than GO bonds because they rely on the success of the project. If the toll road doesn’t get enough traffic or the water system doesn’t generate enough income, the bondholders might not get their full payments.

That’s why you’ll often see covenants attached to revenue bonds. These are legal promises designed to protect the bondholders. They might require the project’s revenue to cover maintenance costs or even mandate fee increases if revenues fall short. It’s all about making sure the money keeps flowing, but investors need to carefully assess the risk associated with the project itself.

Now, here’s the big difference: unlike GO bonds, revenue bonds don’t require voter approval. Why? Because they’re not directly funded by taxes. This makes them an attractive option for governments that want to avoid the political challenges of raising taxes or holding a referendum.

Short-Term Obligation Notes

Now, let’s shift gears and talk about short-term obligation notes. While GO bonds and revenue bonds are more long-term investments, short-term notes—like Tax Anticipation Notes (TANs) and Revenue Anticipation Notes (RANs)—provide temporary funding for municipalities. These notes are typically issued for less than a year and are designed to bridge gaps in funding.

For example, let’s say a city knows it has incoming tax revenue but needs cash to cover immediate expenses. The city might issue a TAN to get the funds now, with the promise to repay the note when the tax revenue comes in. Similarly, RANs are backed by expected revenues from specific sources, like federal grants.

Because these notes are short-term, they’re generally seen as lower risk than longer-term bonds. However, they still depend on the city’s ability to collect the expected revenues on time. For investors, these notes offer a liquid, low-duration investment option with the added benefit of tax-exempt interest income.

Taxable Municipal Bonds

Finally, let’s talk about taxable municipal bonds. These bonds are a bit different from the others we’ve discussed because the interest earned is subject to federal income taxes. Why would anyone want to invest in a taxable municipal bond? Well, these bonds are typically issued for projects that don’t meet the federal government’s criteria for tax-exempt status—think things like sports stadiums or pension funding.

Because the interest is taxable, these bonds tend to offer higher yields to attract investors. They can be a good option for investors who aren’t as concerned with the tax-exempt status and are instead looking for higher returns.

Conclusion

Alright folks, that wraps up our deep dive into Municipal Securities. We’ve covered General Obligation Bonds, Revenue Bonds, Short-Term Notes, and even touched on Taxable Municipal Bonds. These are important instruments that not only provide governments with the cash they need but also offer investors a relatively safe, and often tax-advantaged, way to earn income.

If you’re prepping for the SIE exam, make sure you understand the differences between GO and revenue bonds, as well as the risks and rewards associated with each type of municipal security. And, of course, don’t forget about the tax benefits!

Thanks for tuning in to the FINRA Ninja Podcast. If you found today’s episode helpful, don’t forget to subscribe and leave a review. For more in-depth content, check out finraninja.com, where I have even more resources to help you ace your exam. Until next time, stay sharp and keep learning!