Morningstar Advisor - August/September 2012 - (Page 46)

Spotlight Municipal Bonds 101 By Jeff Westergaard Safety and tax exemption are traditional hallmarks of asset class, but the market has many challenges. The municipal-bond market is one of the mainstays of fixed-income markets for U.S. investors. Muni bonds provide the means by which state and local governments and charitable organizations raise capital to fund all manner of needs. For investors, munis offer two primary benefits: low default occurrence and interest that is usually exempt from federal taxation. In addition, the market is characterized by its incredible diversity of both issuers and individual bonds. There are more than 100,000 unique issuers and 1.5 million individual bonds outstanding, staggering numbers in relation to any other securities market. Taken together, these aspects make the muni-bond market unique among investable asset classes. Here’s a primer on the muni-bond market. A Promise to Pay and, for state and local government issuers, will be determined by what the state legal code allows. At a broad level, these means of repayment are usually categorized as being one of the following: r General obligations: a promise by the issuer to treat the debt obligation as payable from any legally available source, in the case of local governments often from property tax revenues. r Revenue bonds: bonds secured by specifically assigned sources of payment, often times from business like enterprises, such as a water or sewer system. r Leases/certificates of participation: bonds or fractional ownership interests in lease payments made by an obligor, including administrative buildings, correctional facilities and university buildings. The market generally considers generalobligation bonds to be the least risky category. Overall, though, the level of defaults for munis historically is low, many orders less than those of corporate bonds. Municipal-Bond Issuers agencies, cities, counties, towns, school districts, and special districts such as parks or utilities. It is the largest category both in terms of issuers and of bonds outstanding. Charitable organizations consist primarily of hospital and educational organizations that are designated as nonprofit. This is a large component of the municipal market with significant amounts of bonds outstanding. Private activity bonds are paid by entities that generally exist to make commercial profits such as corporations. The usual type of issues in this category is for economic development or pollution control purposes. Tax Treatment Municipal bonds are debt instruments, meaning that the municipal issuer is borrowing money from the bond investor. The issuer stipulates the amount of interest to be paid, the date at which principal will be repaid, and the conditions that will be employed to provide security of repayment. All of these are determined at the time of issuance and are codified in an offering document called the official statement. The means by which any given muni issuer can provide payment security covers a wide range Municipal bonds are the only significant asset class that offers tax advantages to investors in the form of interest that is generally exempt from income taxation. Due to reciprocity agreements, states cannot tax U.S. Treasury debt interest and the Internal Revenue Service does not tax qualifying municipal-bond interest. The tax exemption of interest is a defining characteristic of munis, although not all bonds qualify. A small subset of issues is subject to the alternative minimum tax. This means that the interest on these bonds must be included as a preference item when calculating the AMT for individuals. Because of the uncertainty to Issuers, or more correctly “obligors,” fall into one of three categories: state and local governments; charitable organizations; or private activity organizations. The first category includes states and their 46 Morningstar Advisor August/September 2012

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2012

Morningstar Advisor - August/September 2012
Contents
Contributors
Letter From the Editor
How Much of the Behavior Gap Is Your Fault?
What’s Your View of the Muni-Bond Market?
A Balanced Life
How to Get to Know EMMA
A Strong, Robust Fund Business
Dividend Investing Abroad
Four Picks for the Present
Investment Briefs
Fund Expenses Through the Decades
Autos on Comeback Track
Lessons From the Muni-Bond Rebound
Municipal-Bond Landscape Shifts
Municipal Bonds 101
A Tale of Two Cities
Unraveling the Mysteries of Money
Small Companies Mean the World to Him
The Chinese Art Market and the Origin of Bubbles
The Myth of the Dumb Investor
Stocks That Can Stand the Heat
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The War on Savers

Morningstar Advisor - August/September 2012