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Municipal Securities / Municipal Bonds

Last Updated: 2018

Municipal bonds or municipal securities characterize debt issued in the capital markets by state and local governments to fund various capital infrastructure projects such as roads, bridges, schools, hospitals, and parks. A majority of state and local governments issue debt. In addition to the 50 states, 5 territories, and the District of Columbia (DC), there are 3,031 counties, 35,879 municipalities (cities, town, townships, villages), 38,266 special districts (such as utilities, port authorities, etc.), and 12,880 independent school districts in the United States according to the 2012 U.S. Census of Governments. Almost all of these governments have debt-issuing capacity.

As of the second quarter of 2017, there were over $3.8 trillion outstanding in municipal bonds. The primary holders of municipal securities are high-net-worth individuals, followed by mutual funds, banking institutions, insurance companies, and other entities. Issuers sell municipal bonds in the primary municipal bond market through underwriters or underwriting syndicates. Investors then have the option to sell their bond holdings in the over-the-counter secondary municipal bond market through brokers or broker-dealers. However, due to the buy-and-hold nature of the market, majority of municipal securities rarely trade in the secondary market.

Most municipal securities provide triple-tax-exemption – interest income on these bonds is not subject to federal, state, or local taxes. Such tax preference attracts investors in high marginal income tax brackets who are willing to accept lower interest in return for a lower tax bill. Such tax preference, in turn, allows state and local governments to borrow at more favorable rates compared to corporations and other institutional borrowers.

There is significant heterogeneity in the municipal bond market both in terms of issuers as well as products. Municipal bonds can be short or long-term, general obligation or revenue-backed, with varying capital purposes, use of proceeds, call features, credit ratings, credit enhancements, and other complexities. The main regulatory agency in the municipal bond market, the Municipal Securities Rulemaking Board (MSRB) created by Congress in 1975, operates with a mission to protect issuers, investors, the public, and, since 2010, state and local governments.

Interest on a small subset of municipal bonds is not tax-exempt if the federal and/or state governments deem the use of these bond proceeds to be of insignificant public value. Since the passage of the 16th Amendment, which established income tax laws, the legality of the municipal bond interest taxation has been widely debated. In the 1988 Supreme Court case South Carolina v. Baker, the state of South Carolina challenged whether the federal government could tax interest earned on any municipal bonds and the court ruled in favor of the federal government’s power to tax.

The municipal bond market tends to have a local flavor due to significant variation in the tax-exempt status of municipal bonds at the state level. With a few exceptions of reciprocity, double exemption at both the federal and state levels applies only to debt issued within the state of the investor’s residence. The Kentucky Court of Appeals, Davis v. Department of Revenue of Kentucky, ruled such discriminatory tax treatment unconstitutional in 2006, which was later overturned by the U.S. Supreme Court in 2008. Thus, this local flavor still encourages investors to purchase bonds issued by their state and local governments.

SEE ALSO: Intergovernmental Tax Immunity


Denison, D. V., M. Hackbart, and M. J. Moody (2009). “When states discriminate: The non-uniform tax treatment of municipal bond interest.” Public Administration Review 69(3), 458 – 468. 

Hildreth, W. B. and C. K. Zorn (2005). “The evolution of the state and local government municipal debt market over the past quarter century.” Public Budgeting and Finance 25(4), 127–153. 

Marlowe, J. (2015). “Municipal bonds and infrastructure development – past, present, and future.” A Policy Issue White Paper Prepared on behalf of the ICMA Governmental Affairs and Policy Committee. 

SEC (2012). “Report on the municipal securities market.” U.S. Securities and Exchange Commission.