Taxable Municipal Bonds

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on May 23, 2023

What Are Taxable Municipal Bonds?

Taxable municipal bonds are debt securities issued by state and local governments or other government entities to finance public projects that do not qualify for tax-exempt status under federal law.

Unlike tax-exempt municipal bonds, the interest income earned from taxable municipal bonds is subject to federal income tax and, in some cases, state and local taxes.

These bonds are used to fund projects such as stadiums, pension obligations, refinancing existing debt, or other initiatives that primarily benefit private entities.

Purpose of Taxable Municipal Bonds

Taxable municipal bonds is issued when the funds raised from the bond issuance will be used for purposes that do not qualify for tax-exempt status under federal law.

For example, financing a stadium or other projects that primarily benefit private entities may require issuing taxable bonds. Additionally, taxable bonds can be used to finance pension obligations or to refinance existing debt.

State and local governments, public authorities, and other government entities issue taxable municipal bonds. These issuers may include cities, counties, school districts, public utilities, and special districts.

Types of Taxable Municipal Bonds

There are several types of taxable municipal bonds, including general obligation bonds, revenue bonds, and Build America Bonds (BABs).

General Obligation Bonds

General obligation (GO) bonds are backed by the full faith and credit of the issuing government entity. They are repaid through general tax revenues and may require voter approval.

The security and repayment of GO bonds come from the taxing power of the issuing government. This means that the issuer pledges its full financial resources to repay the bondholders.

In many cases, GO bonds must be approved by voters before issuance, ensuring that the community supports the projects being financed.

Revenue Bonds

Revenue bonds are repaid from the revenues generated by the project being financed or from a specific revenue source.

The security and repayment of revenue bonds come from the income generated by the financed project, such as tolls from a highway or fees from a water treatment facility.

Revenue bonds are often used to fund projects such as airports, toll roads, hospitals, and utilities.

Build America Bonds (BABs)

Build America Bonds are a type of taxable municipal bond introduced under the American Recovery and Reinvestment Act of 2009.

BABs were created to stimulate infrastructure investment and lower borrowing costs for state and local governments during the financial crisis.

Issuers of BABs can choose between two options: a tax credit BAB, where investors receive federal tax credits, or a direct payment BAB, where issuers receive direct payments from the federal government.

Pros of Taxable Municipal Bonds

Taxable municipal bonds offer several advantages for both issuers and investors.

Lower Borrowing Costs for Issuers

Taxable municipal bonds often have lower borrowing costs compared to traditional corporate bonds, as they carry lower default risk.

Diversification for Investors

Investing in taxable municipal bonds can provide portfolio diversification, as they are not highly correlated with other asset classes.

Potential for Higher Yields Compared to Tax-Exempt Bonds

Due to their taxable status, taxable municipal bonds typically offer higher yields compared to tax-exempt bonds, making them more attractive to certain investors.

Broad Investor Base

Taxable municipal bonds can be purchased by a wide range of investors, including foreign investors and pension funds, which are not eligible to benefit from tax-exempt bonds.

Cons and Risks of Taxable Municipal Bonds

Investing in taxable municipal bonds comes with some disadvantages and risks, including interest rate risk, credit risk, call risk, liquidity risk, and tax implications for investors.

Interest Rate Risk

Changes in interest rates can affect the market value of taxable municipal bonds, as bond prices typically move inversely to interest rates.

Investors holding bonds with longer maturities may experience more significant price fluctuations due to interest rate changes.

Credit Risk

Credit risk refers to the possibility that the issuer of the bond may default on its payment obligations. Although municipal bonds generally have low default rates, investors should still consider the credit quality and financial stability of the issuer before investing.

Call Risk

Some taxable municipal bonds have call provisions, allowing the issuer to redeem the bond before its maturity date. This can be disadvantageous for investors, as they may not receive the full interest payments they initially anticipated.

Liquidity Risk

Taxable municipal bonds can sometimes be less liquid than other types of bonds, meaning that it may be challenging to sell the bond at a fair price when needed.

Tax Implications for Investors

Unlike tax-exempt municipal bonds, the interest income generated from taxable municipal bonds is subject to federal income tax and, in some cases, state and local taxes as well.

Pros and Cons of Taxable Municipal Bonds

Investing in Taxable Municipal Bonds

Investors can choose between individual bonds and bond funds when investing in taxable municipal bonds.

Individual Bonds vs. Bond Funds

Purchasing individual bonds provides more control over the selection of specific bonds, while bond funds offer instant diversification and professional management.

Evaluating Credit Quality and Ratings

Before investing, it is essential to evaluate the credit quality of the bond, using credit ratings provided by agencies such as Moody's, Standard & Poor's, and Fitch Ratings.

Assessing Interest Rates and Yield

Understanding current interest rates and comparing the yield on taxable municipal bonds to other fixed-income securities is crucial in making informed investment decisions.

Tax Implications and Planning

Investors should consider the tax implications of investing in taxable municipal bonds and incorporate them into their overall tax planning strategy.

Diversification Strategies

Including a mix of taxable and tax-exempt municipal bonds in a portfolio can provide diversification and help manage risk.

Market Trends and Developments

Several trends and developments may impact the taxable municipal bond market, including federal tax policy, infrastructure spending, credit quality trends, and market innovations.

Impact of Federal Tax Policy on Demand

Changes in federal tax policy can influence the demand for taxable municipal bonds. For example, lower tax rates may reduce the attractiveness of tax-exempt bonds, increasing demand for taxable bonds.

Infrastructure Spending and Municipal Bond Issuance

Increased infrastructure spending may lead to a higher issuance of taxable municipal bonds, as state and local governments seek to finance various public projects.

Credit Quality Trends and Potential Risks

Monitoring credit quality trends and potential risks can help investors make informed decisions about their bond investments.

Innovations in the Municipal Bond Market

New products and innovations, such as green bonds and social impact bonds, may provide additional investment opportunities in the taxable municipal bond market.

Conclusion

Taxable municipal bonds play a critical role in public finance, offering a means for state and local governments to fund projects that do not qualify for tax-exempt status.

Investors should consider the advantages, disadvantages, and risks associated with taxable municipal bonds when constructing their portfolios.

By staying informed about market trends and developments, investors can make better decisions and capitalize on opportunities in the taxable municipal bond market.

Taxable Municipal Bonds FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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