A Primer on Muni Bonds

Municipal Bonds
Municipal bonds are debt obligations issued by public entities. These entities use the loans to
fund public projects such as the construction of schools, bridges, highways, water and sewer
systems and hospitals.

Tax Exempt Federally and Often at the State and Local Level
Municipal bonds offer a source of income free from federal and sometimes state and local
income taxes.

The interest earned on most muni bonds is exempt from federal income tax and, in some cases,
state income taxes as well. By contrast, the interest earned from corporate bonds is subject to
taxation at both the federal and state level. It is important for investors to compare what their
after tax yield will be when deciding to invest in taxable versus tax exempt muni bonds. It is all
what the investor keeps in his or her pocket that matters at the end of the day. For example,
lets take an investor in the highest federal income bracket of 39.6% bracket. This investor might
be able to earn a 4% yield by investing in a municipal bond. This begs the question of what is
that 4% worth if it were a taxable bond. In other words what will the muni bond investor have to
earn as a taxable equivalent to equal that hypothetical 4% yield. This is called the taxable
equivalent yield. In the example of the 4% tax free yield, taking into account the 39.6% tax
rate, the taxable equivalent yield is 6.62%. To arrive at this taxable equivalent yield you take
ones tax rate and apply it to the stated rate of return. This is detailed below.

For example 1-.396 (39.6% income tax rate) = .604. Then divide this reciprocal number into the
yield to arrive at the taxable equivalent yield. In our example with a 4% yield; 4 divided by .604
is 6.62%. The exercise above demonstrates that investors in the highest tax brackets often can
keep more of their yield by investing in municipal bonds than by investing in taxable alternatives.

Finally, if an investor purchases bonds that are also free of taxes on a state or local level than
the advantage is even greater. If one factors a state income tax rate of 7% the 39.6% becomes
46.6% and the taxable equivalent yield of that 4% bond in our example is now 7.49%.

Low Default Rates

Historically, municipal bonds have had a lower default risk and lower volatility compared to
taxable bonds of comparative credit and maturity.
The average cumulative default rate on all AAA munis from 1970-2011 as compiled by Moodys
Ratings is .00% or ZERO. The average cumulative default rate for AA munis was a mere .03%.
So for every 10,000 issuers just 3 went into default. And it has been shown that while there may
have been isolated instances of defaults actually bondholder recoveries have been considerably
higher than comparable corporate or sovereign issuers.
Source: Special Comment US Municipal Bond Defaults and Recoveries 1970-2011, Moodys
March 7, 2012 Report
Credit quality has historically been very strong in the municipal sector since municipal
governments have ability to secure their debt with a general obligation or GO pledge. This GO
debt is secured by the full faith and credit and taxing power of the issuer. This ability to raise
taxes as needed to pay principal and interest is what has provided the bedrock of strength and
stability for this well-rated debt. General Obligation bonds are typically sold to fund capital
improvements such as for schools, roads or parks within a municipal issuers borders. Revenue
bonds, which are paid back by revenues generated from a particular enterprise, such as an
infrastructure project like a bridge, tunnel, and sewer system can also be high quality bond
assets if the correct ones are selected.

Types of Municipal Bonds Generally

In general, municipal bonds fall into one of two categoriesgeneral obligation or revenue
bonds. The category that the bond falls into is based on the source of their interest principal
payments. General obligation bonds are typically funded by tax collections for a specific
municipality, while revenue bonds rely on pledged revenue from a specific underlying project.
However, within these categories, a municipal bond can be structured in different ways, with
each variation offering different benefits, risks, and tax treatments. While most municipal bond
investors think of these bonds as tax-exempt investments, this may not always be the case, as
there are instances where the income generated by a municipal bond may be taxable. For
example, a municipality may issue a bond that does not qualify for federal tax exemption,
resulting in the income generated by that bond being subject to federal taxes. Thus since there
are nuances and distinctions, it is quite important to consider all aspects of a particular bond
before making an investment.

General Obligation Bonds (GOs)

General obligation bonds are issued by governmental entities and repayment generally comes
in two forms. Some general obligation bonds are backed by dedicated taxes on property, while
others can be payable from general funds. The latter types of bonds are often referred to as
"backed by the full faith and credit" of the governmental entity. While in many instances,
"general obligation" means that the bond issuer has unlimited authority to tax residents to pay
bondholders. Certain types of GO bonds are known as LT GOs or limited general obligations
and here the issuer or governmental entity may have limited or no taxing authority.

Revenue Bonds
Principal and interest payments for revenue bonds are secured by revenues generated by the
issuer or by certain taxes such as water usage fees, road tolls, sales tax, fuel tax, or hotel
occupancy taxes. See our article on water bonds for some more in depth discussion at
www.municipalinfrastructurebonds.com

The issuers of revenue bonds are generally:

Entities that provide a public service (such as utilities and public transportation authorities).
Non-profit organizations (501(c)(3)).
Private-sector corporations (universities and hospitals).
Risks of Municipal Bond Investing
Credit Risk
Credit risk is defined as the risk that the bond issuer may experience if financial problems make
it difficult or impossible to pay interest and principal in full, this is also called a default. Credit
ratings can give some indication as to the bond's ability to pay timely interest and principal, but
are not a guarantee of the repayment ability. Standard & Poors, Moody's, Fitch and Kroll are
the four most noteworthy approved rating agencies in the municipal bond market.

Interest Rate Risk

Bonds are issued with a face value, known as the par value. If an investor holds a bond to
maturity and there is no default as to payment of principal or interest then investor will receive
the face value amount back, plus interest. The value of a municipal bond will fluctuate over the
life of the bond as market conditions change. During a time of rising interest rates, bondholders
will be exposed to interest rate risk. The price of a municipal bond moves inverse to the yield.
The bonds market price will move up as interest rates move down and it will decline as interest
rates rise, so that the market value of the bond may be more or less than the par value. So, as
interest rates rise, the price (value) of a bond will fall. Investors who do not hold their bonds to
maturity are exposed to interest rate risk if they attempt to sell their bonds into a rising interest
rate market. The higher the fixed coupon rate a bond has the less sensitive it will be to rising
interest rate movement.

Call Risk
Call risk refers to the potential for an issuer to repay a bond
before its maturity date, something that an issuer may do if
interest rates decline. The basic premise is that an investor
should be aware of her yield to the call date. If the issuer, which
can be compared to a homeowner who refinances her home
mortgage when rates are favorable for her, refinances and calls
the bond away, the investor needs to understand what that yield
Muni Bond Risks
to the call worst possible call date would be in that scenario. Credit Quality Decline
Interest Rate Risk
Liquidity Risk Liquidity Risk
Liquidity is defined as the degree to which and asset or security
can be quickly bought or sold in the market without affecting the
assets price Liquidity risk refers to the risk that a holder of a
municipal bond will not be able to find a robust, active market to
buy or sell their position at a given time. This lack of a market could discourage a holder from
transacting a bond when they wanted and at a price they desired. The depth of market varies
dramatically between issuers, so it is important to consult a professional. Typically municipal
bond investors are holding their positions to maturity, but lack of liquidity or liquidity risk can be
a shock if they need to sell prior to then.
Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or
personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an
investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to
change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are
considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Fixed income securities are subject to
increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in
credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. All bonds and
market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any
security. Supporting documentation for any claims or statistical information is available upon request. Municipals and tax-exempt bonds are not
necessarily a suitable investment for all persons. Information related to a securitys tax-exempt status (federal and in-state) is obtained from third-
parties and Las Olas Wealth Management of Nat Alliance Securities LLC does not guarantee its accuracy. Tax-exempt income may be subject to
the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital
gains are not exempt from federal income tax.

Dean Myerow is a municipal bond market asset manager and along with partner, Sean
Vesey the team structures institutional and high net worth investor portfolios at Las Olas
Wealth Management of NatAlliance Securities LLC.