Municipal and Corporate Debt Securities
Domain 4 - Municipal and Corporate Debt Securities
This domain tests the structure, taxation, and disclosure rules for tax-exempt municipal bonds and corporate debt, including how yields are compared across the two markets.
Municipal bonds
- General obligation bonds are backed by the issuer's taxing power; revenue bonds are backed by project cash flows and are usually higher risk.
- Interest is generally exempt from federal income tax and, for in-state residents, state tax. It still counts in the Social Security benefit taxation formula and can trigger AMT if the bond is a specified private-activity bond.
- Serial bonds mature in installments; term bonds mature on one date, often with a sinking fund.
- MSRB rules govern dealers: G-30 requires disclosure of price and compensation on retail trades; official statements and continuing disclosures are posted on EMMA.
- Premium bonds must be amortized against basis; market discount is taxed as ordinary income at maturity or sale unless the de minimis exception applies.
Corporate bonds
- An indenture names a trustee and sets covenants (affirmative, negative, restrictive). Call features favor the issuer; puts favor the holder.
- Convertibles embed an equity option; their price tracks both the bond floor and the conversion value.
Worked example
A 3.00% municipal bond yields 3.00% tax-free. For an investor in the 32% bracket, the taxable-equivalent yield is 3.00 ÷ (1 − 0.32) = 4.41%. A corporate bond must beat 4.41% to be preferable on an after-tax basis.
Traps
- Comparing a muni's yield directly with a taxable bond's yield.
- Assuming all municipal interest escapes state tax - most states exempt only their own issuers.
- Believing a revenue bond carries a general taxing pledge.