Municipal Taxation and Market Analysis

Interest, gains, and the state layer

Interest on a state or local government bond is generally excluded from gross income for federal income tax purposes under Internal Revenue Code section 103. That is why a municipal yields less than a corporate of the same credit quality: the buyer is paid partly in tax that never becomes due.

States generally exempt the interest on their own bonds from state income tax and tax the interest on other states' bonds. So an in-state buyer in a high-tax state gets a double exemption — federal and state — and an out-of-state buyer gets only the federal one. This is why municipal funds are commonly offered in single-state versions.

Bonds issued by US territories — Puerto Rico, Guam, the US Virgin Islands, American Samoa and the Northern Mariana Islands — are exempt from federal, state and local income tax in every state. They are the triple-tax-exempt securities, and they are the answer whenever a question describes a customer who wants full exemption but does not live in a state whose bonds they want to buy.

Capital gains are a different matter entirely and this is where customers get surprised. The exemption covers interest, not appreciation. If a customer buys a municipal at 90 and sells at 96, the six points are a taxable capital gain. A municipal bond is not a tax-free investment; it is a tax-exempt-interest investment.

The AMT exception: under IRC section 57(a)(5), interest on specified private activity bonds is an item of tax preference for the alternative minimum tax. The interest stays exempt from regular federal tax and can be effectively taxed for a customer subject to the AMT. Before recommending a private activity bond for its exemption, you need to know whether the customer is exposed.

Taxable equivalent yield

To compare a municipal with a taxable bond, gross the municipal yield up to what a taxable bond would have to pay to leave the investor equally well off.

Taxable equivalent yield equals the municipal yield divided by one minus the investor's marginal tax rate.

A 3.5 percent municipal to an investor in the 35 percent federal bracket: 3.5 divided by 0.65, which is 5.38 percent. A taxable bond must yield more than 5.38 percent to beat it.

When an in-state bond gives a state exemption too, use the combined marginal rate. An investor at 35 percent federal and 6 percent state faces a combined rate of 41 percent, so the same 3.5 percent municipal is equivalent to 3.5 divided by 0.59, or 5.93 percent. The state layer moves the answer materially, which is why the exam bothers to include it.

The reverse calculation — after-tax yield of a taxable bond — is the taxable yield times one minus the tax rate. A 6 percent corporate to the 35 percent taxpayer nets 3.9 percent, which beats the 3.5 percent municipal on a federal-only comparison and loses to it once the state exemption is counted.

The structural consequence, worth understanding rather than memorizing: because the value of the exemption rises with the marginal rate, municipals are suitable for high-bracket investors and unsuitable for low-bracket ones. And they are actively inappropriate inside a tax-deferred account — an IRA or a 401(k) — where the customer would be accepting a lower yield to buy an exemption they already have. That is one of the most reliable suitability questions on the exam.

Discount, premium, and the de minimis rule

Three different discounts, three different tax answers. This is the most error-prone corner of municipal taxation and it repays careful reading.

Original issue discount on a municipal. The bond was issued below par. The accretion of that discount is treated as tax-exempt interest, and it raises the holder's cost basis each year. A municipal OID bond held to maturity therefore produces no capital gain at redemption — basis has accreted to par. No tax is due on the accretion and none is due at maturity.

Market discount on a municipal. The bond was issued at par and the investor bought it below par later, because rates rose. That discount is not tax-exempt interest; it is compensation for a price change, and the accrued market discount is taxed as ordinary income when the bond is sold or redeemed. This is the trap: two municipal bonds bought at the same price can have entirely different tax outcomes depending on where the discount came from.

The de minimis rule limits the reach of that treatment. A discount is de minimis — treated as zero, so the eventual gain is a capital gain rather than ordinary income — if it is less than one-quarter of one percent of the redemption price multiplied by the number of full years to maturity. A $1,000 bond with ten years remaining has a de minimis threshold of 0.0025 times 1,000 times 10, which is $25. Bought at $980, the $20 discount is inside the threshold and is de minimis; bought at $970, the $30 discount is not.

Premium on a municipal. Amortization is required, not elective. The premium is written down over the remaining life, reducing basis toward par, and the amortization is not deductible — it is simply an adjustment reflecting that part of the above-par purchase price is buying tax-exempt interest. A municipal premium bond held to maturity therefore produces no capital loss at redemption, because basis has amortized to par. A customer who expects to claim a loss on a premium municipal at maturity has misunderstood, and the representative is the person who should have said so.

On a taxable bond, by contrast, amortization of premium is an election.

Market indicators

The outline names the municipal market's published indicators, and they are straightforward facts to memorise.

The Bond Buyer 20 Bond Index averages the yields on twenty general obligation bonds of about twenty-year maturity and roughly double-A quality. It is the broad municipal yield benchmark.

The Bond Buyer 11 Bond Index is a higher-grade subset of those same twenty issuers, so it yields slightly less.

The Revenue Bond Index — RevDex — averages twenty-five revenue bonds of roughly thirty-year maturity, which makes it the revenue-side counterpart.

The Municipal Bond Index, commonly the 40 Bond Index, tracks forty actively traded dollar bonds and is stated as an average price rather than a yield.

Two supply and demand measures accompany them. The thirty-day visible supply is the par value of new issues expected to come to market over the next thirty days — rising supply pressures prices. The placement ratio, or acceptance ratio, is the proportion of the week's new issues that underwriters actually sold, and it measures demand.

On the secondary market side, dealer offerings were historically circulated in The Blue List. Today the authoritative disclosure venue is EMMA — the MSRB's Electronic Municipal Market Access system — which publishes official statements, continuing disclosure filings and real-time trade prices, and which a representative is expected to use when researching a municipal for a customer.