What is a Zero Coupon Municipal Bond?

Municipal bonds, or “munis,” are a debt instrument issued by government entities, such as cities, counties and states.  Generally munis are used to generate capital for public improvements, such as sewers and roads.  Munis are similar to a corporate bond in that they are rated by credit agencies such as Moody’s and S & P.

Most municipal bonds have a coupon rate, which pays a regular dividend during the term of the bond until maturity.  However, zero coupon municipal bonds were introduced in the early 1980s for investors who were not interested in a regular income stream, but rather wanted the benefit of purchasing a short-term, low risk bond with a single interest payment at maturity.  Zero coupon municipal bonds offer no interim “coupons,” or dividend payments.

Benefits of a Zero Coupon Municipal Bond

There are many benefits for investors who allocate part of their wealth into zero coupon municipal bonds.

• Tax Free – The government wants to encourage investment in public works.  Thus, most zero coupon municipal bonds are tax exempt, making them an attractive alternative to corporate bonds.  Generally, an investor within a higher tax bracket will benefit the most from a tax free zero coupon municipal bond.

• Better Credit Rating – Zero coupon municipal bonds are rated by at least one of the major rating agencies.  A majority of all zero coupon municipal bonds generally are good quality and are rated A or better.  In fact, many zero coupon municipal bonds carry insurance guaranteeing from default.  These bonds usually are rated AAA or better.

• Low Minimum Investment – Since zero coupon municipal bonds offer only a single interest payment at the maturity date, they are usually heavily discounted from the face value.  For instance, a 20-year, $20,000 zero coupon municipal bond may sell for about $6,700.  At maturity in 20 years the bond will pay $20,000, usually tax free.

• Liquidity – Zero coupon municipal bonds have many ranges of terms.  There are many short-term zero coupon municipal bonds in the 3 to 5 year maturity range.  This offers investors great liquidity in being able to sell the bond if they are in need of cash during the term.

Where Can You Buy a Zero Coupon Municipal Bond?

Investors can purchase zero coupon municipal bonds directly from the issuing government when the bonds are first issued.  There are many websites that offer information about new zero coupon municipal bond issues, such as the US Department of the Treasury.

However many investors do not wish to perform the research for newly listed zero coupon municipal bonds and would rather purchase through an investment brokerage house.  Most major brokerage firms deal with secondary sales of zero coupon municipal bonds.  Check with your investment broker if you are interested in putting part of your wealth in zero coupon municipal bonds.

Simply put, a revenue bond is issued by a locality to financially support a specific public works project. The revenues that this public works project makes are then used to further support the projects existence. Revenue bonds are considered by many to be the second most secure type of municipal bond and are sometimes referred to as municipal revenue bond.

In essence, this is a type of municipal bond that is repaid by taxes collected from those who are appreciating (hopefully) the development or service that the project was funded for. An assessment bond is also sometimes referred to as a special purpose bond since the projects that they often fund are for the good of the community. An example; A local community sees their local facilities improved and a recreation facility produced. This not only increases the value of their homes as their neighbourhood sees a rise in value, it benefits them as individuals. However, with increased value come increased taxes, which of course are used to fund the project in the first place.

The general obligation refers to a pledge which is a set of conditions that state how a local or national government can issue or repay general obligation debt, including its securities. More often than not – as already mentioned – the use of land or property taxes and levying these in order to satisfy the borrowing of the debt requirements. Understandably those who own property are reluctant to lose their property because of unpaid taxes therefore the may consider using a credit agency to make a general obligation pledge for strong credit quality and assign a investment grade rating. This basically means that if property owners are late or miss their property tax payments their tax rate increases and the owner will indefinitely have to pay a higher rate the following year.

It is important to note that state laws determine the conditions of which a local government can issue general obligation debt and these have two forms;

• Limited tax general obligation pledge – Local government to levy property tax to meet debt obligations. It’s limited because the government can choose only a section of the tax that it decides to levy.
• Unlimited tax general obligation pledge – Identical to the limited but the government has a free reign to levy any tax rate they feel is necessary.

There are three most common types of repayment source for municipal bonds, these are;

• General Obligation Bonds – These are well known for their security and low interest rates, the agreement is to repay in full the credit given by the issuer.
• Revenue Bonds – These are most common in active, working projects and investments as the agreement is to repay based of a channel of past, present and future incomes. An example would be a share of the income a power plant may generate.
• Assessment Bonds – These involve the repayment based on taxes, usually land taxes or property taxes located within the domicile of the issuer.

There are a number of other types of municipal bond repayment sources but the above three are the most common.

Depending on the value or importance of the municipal bond, you will quite often see external or third parties involved in reviewing and guaranteeing a repayment source or agreement. Typically the agreement is reviewed and then rated by the external agency, both sides of the municipal bond ie; investment holder/issuer will receive a copy of the review and the assigned bond rating.

In the United States of America there are three rating agencies most commonly used, these are; Fitch, Moody’s and Standard & Poor’s.

When a municipal bond is initiated, the issuer normally receives a cash payment in exchange for an agreement to provide the investor who provided the cash payment, a repayment over an agreed time period. The standard repayment periods for municipal bonds can be anything from six months to 10-30 years, perhaps even longer. The shorter periods are quite rare and you would be hard pressed to find investments for such a short period of time unless either the sum being borrowed is low or the repayment period can be guaranteed. Typically, 20+ years is the industry standard.

The purpose of municipal bond investing would be to use the investment from a bond sale to pay for the project that it is being invested for, typically this is a project or a long term capital investment or development. Depending on the stipulations of the bond offering, all of the capital raised from a bond sale may be used immediately or provisions put in place to spread it over a period of time.