What it means
Governments borrow by issuing municipal bonds to pay for roads, schools, hospitals, water systems and similar projects. Many of these bonds pay interest that is exempt from federal income tax, and sometimes from state tax too, which makes them popular with higher-earning investors.
Because the market is large and fragmented, regulators want those who sell the bonds to be properly tested. The Series 52 exam covers the types of municipal bonds, such as general obligation bonds backed by the issuer's taxing power and revenue bonds backed by the income from a specific project.
It also covers pricing, yields, the primary and secondary markets, customer suitability, and the rules set by the Municipal Securities Rulemaking Board. FINRA administers the exam, while the board writes many of the underlying rules.
For a business reader, the exam is a reminder that the tax angle drives the product. A municipal bond with a lower stated yield can still beat a taxable bond once tax savings are counted, so a good representative explains the comparison in terms of what the investor keeps after tax.
Treasury teams at companies and charities with taxable income sometimes consider the same trade-off. Credit quality also matters.
Municipal issuers can run into financial difficulty, and revenue bonds depend on a single project generating enough income to pay investors. Representatives must be able to explain these risks, not just the tax benefits.
Requirements change over time, and a representative generally needs to satisfy co-requisites set by FINRA. Compliance teams should check current rules before assuming that any individual is qualified.
State taxes add another layer. Many investors prefer bonds issued within their own state because the interest may escape state as well as federal tax, so a representative needs to ask where the customer lives before recommending a particular issue.
Getting this wrong can turn an apparently attractive yield into an ordinary one.
In practice
Real-world examples.
Example
A broker-dealer wants to sell a new school district bond to its wealthier clients. Only staff holding the municipal securities representative qualification are allowed to take the orders. The sales manager checks the list before the offering opens.
Example
A financial adviser compares a 3.5% municipal bond with a 5% corporate bond for a client in a high tax bracket. She calculates the after-tax return of each and shows the client the result in dollars. The client chooses the municipal bond for a $200,000 portion of the portfolio.
Example
A hospital system plans to issue revenue bonds and meets underwriters. The CFO asks whether the sales team that will place the bonds holds the right registrations and understands the project's cash flows. She wants investors to receive accurate information about the risks.
Formula
Calculation
Tax-equivalent yield = municipal yield / (1 - investor's tax rate)
Suppose an investor in a 25% tax bracket is offered a tax-exempt municipal bond yielding 4%. Tax-equivalent yield = 4% / (1 - 0.25) = 4% / 0.75 = 5.33%. A taxable bond must yield more than 5.33% to leave the investor better off after tax. On a $100,000 holding, the municipal bond pays $4,000 tax free, while a taxable bond yielding 5.33% would pay $5,330, of which $1,332.50 goes in tax, leaving about $4,000.Case study
Seen in the real world.
Lakeshore Capital is an illustrative, fictional brokerage that wanted to build a municipal bond desk. It had experienced equity salespeople, but none had municipal qualifications.
The head of the desk planned a six-week study programme and set a rule that nobody could take a municipal order until they had passed. During the wait, two experienced municipal sales assistants from another firm were hired to help the team learn the market.
The desk began trading in the third month and earned about $600,000 in its first year. The illustrative lesson is that a specialist product needs specialist people, and the tax features of the bonds can only be sold responsibly by staff who understand them.
Watch out
Common mistakes.
- Assuming municipal bonds are risk free because governments issue them, when some issuers have defaulted or run into severe difficulty.
- Comparing a tax-exempt yield directly with a taxable yield, without adjusting for the investor's tax rate.
- Believing that all municipal bonds are exempt from all taxes, when exemptions depend on the bond type, the investor's location and the tax rules in force.
Questions
People also ask.
What is a general obligation bond?
It is a municipal bond backed by the issuer's general power to tax, rather than by the income from a single project.
Who writes the rules for municipal securities?
The Municipal Securities Rulemaking Board writes many of the rules, and FINRA and other regulators enforce them and administer the qualification exams.
Why do municipal bonds often have lower yields?
Because the interest is frequently tax exempt, so investors accept a lower stated rate in return for keeping more of it after tax.
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