Types of Municipal Bonds

There are many different types of municipal bonds, though a single bond may fall into several of the following overlapping categories:

General obligation/revenue bonds

General obligation, or GO, bonds are backed by the issuer's taxing power; the issuing body may raise taxes to cover the interest payments if necessary. However, some municipal bonds make their payments from the revenue derived from the project that a specific bond funds--for example, a power plant or a turnpike that collects tolls. Such bonds are known as revenue bonds, and are generally considered slightly less secure than GO bonds.

Private-activity bonds

As is true of almost anything that's related to taxes, munis can get complicated. Specific municipal issues may be subject to federal income tax, depending on how the bond issuer will use the proceeds. If a bond finances a project that offers a substantial benefit to private interests, it generally is taxable at the federal level unless specifically exempted.

For example, even though a new football stadium may serve a public purpose locally, it will provide little benefit to federal taxpayers. As a result, a muni bond that finances it is considered a so-called private-activity or private-purpose bond and may be taxable at the federal level.

Other examples of publicly financed projects whose bonds may be federally taxable include:

• Housing
• Student loans
• Industrial development
• Airports

In some cases, a private-activity bond may be specifically exempted from regular federal tax. However, even if a bond is exempt from federal income tax, the interest may still have to be considered when calculating whether the alternative minimum tax (AMT) applies to you (see "Municipal Bonds and Tax Planning").

Zero-coupon bonds

While most municipal bonds pay periodic interest, a zero-coupon bond makes a single payment at maturity. You buy zeros at a discount, meaning the purchase price is lower than the bond's face value. When a zero matures, the difference between the purchase price and the face value is the return on your investment.

A bond's interest and principal also can be divided, or stripped, into separate components, each of which can be sold individually. For example, a 20-year bond could be sold as 41 different investments, each of which becomes known as a zero-coupon bond, or zero. One, based on the principal, pays the bond's full face value on the bond's maturity date. The other 40 represent the 40 semiannual interest payments, each of which matures on the specific date when that interest payment is scheduled to be made.

Zeros do not have to be held until maturity; they can be traded on the open market just as any other bond can. In general, the further away a zero's maturity date is, the less you will pay for it. Because they are bought at a discount, you may be able to buy more zero-coupon bonds for your money than other types of bonds. A zero also offers the opportunity to lock in a particular rate of return as long as you hold it to maturity. However, you should be aware that the prices of zeros go up and down in the opposite direction from interest rates more dramatically than any other type of bond. When interest rates rise, a zero's price will tend to fall more rapidly than other bonds because its single payment is fixed and cannot rise over time. When interest rates fall, a zero's price will rise because that single payment will stay the same instead of dropping.

Though zero-coupon bonds pay no return until they mature, they are taxed as if you receive a portion of the return each year; that is known as imputed interest. However, that is less of a concern with municipal-bond zeros because they are generally exempt from federal tax.

Floating-rate bonds

The interest on some municipal bonds, informally called floaters, is adjusted periodically based on the performance of another security or interest rate index. For example, a floating-rate note might specify an interest rate that equals the current Treasury bill rate plus a certain number of basis points (a basis point equals 1/100th of a percentage point).

Floating-rate munis offer an investor the ability to adjust to changing interest rates without having to pay the transaction costs of constantly reinvesting in short-term debt instruments. A variation on a floating-rate bond is what's called a step-up bond, which pays one coupon rate until a specified date (usually the call date). If the bond is not called by then, the coupon rate is increased, thus stepping up the interest payments.

Refunded and pre-refunded bonds

Bond issuers sometimes choose to issue new bonds to pay off the obligations of older bonds, in somewhat the same way that a homeowner might refinance a home mortgage to obtain a lower interest rate. The proceeds of the new bond or bonds can be used to replace a specific revenue source that was pledged to repay the interest and principal of older bonds (for example, a tax collected by the issuer or the revenues of a bond-funded project).

The money obtained from issuing the newer bond is generally put into escrow and paid out over time as the older bond's obligations come due. Because the older bond no longer relies on its original funding source but on the escrowed proceeds, the older bond is then considered a refunded bond.

Bonds that are refunded through their maturity dates are said to be "escrowed to maturity." The escrowed money is typically invested in or collateralized by U.S. Treasury securities that are scheduled to mature as the refunded bond's interest and principal payments become due. If a refunded bond's original documents include a call provision that allows the issuer to pay off the bond before its maturity date, the bond is referred to as a pre-refunded bond.

Because refunding typically occurs after interest rates have fallen, refunded bonds generally offer a higher coupon rate than equivalent newer issues and sell at a premium. Also, because they are backed by escrowed money invested in or collateralized by Treasury securities, they generally are considered to be of similar high quality, though a refunded bond itself is not backed by the full faith and credit of the U.S. Treasury as to the timely payment of principal and interest.