Municipal notes

What Are Municipal Notes?

Municipal notes are a type of short-term debt instrument issued by state and local governments and their agencies. As part of the broader category of fixed income securities, municipal notes are typically used for temporary debt financing needs, such as managing cash flow imbalances or providing interim funding for projects that will eventually be financed through a long-term municipal bond issuance. These notes generally have maturities ranging from a few months up to three years, distinguishing them from longer-term municipal bonds. Like many municipal securities, interest earned on municipal notes is often exempt from federal income taxes and, in some cases, from state and local taxes for residents of the issuing jurisdiction, enhancing their appeal to certain investors.

History and Origin

The concept of states and municipalities issuing debt to fund public projects dates back centuries. In the United States, municipal finance became more formalized in the 19th century as infrastructure development grew. The tax-exempt status of municipal debt, a key feature, has roots in historical legal interpretations and congressional actions. When a federal income tax was introduced in 1861, municipal bond interest was initially taxed. However, a pivotal 1895 Supreme Court ruling found the federal income tax unconstitutional, also stating that taxing state and local bond interest would infringe on constitutional principles preventing the federal government from taxing state activities. The 16th Amendment later granted Congress the right to impose a federal income tax, leading to the 1913 Revenue Act, which explicitly excluded municipal bond interest from income tax calculations.⁵

Over time, short-term instruments like municipal notes evolved as flexible tools for government entities to manage immediate financial needs without committing to long-term borrowing. Specific types of municipal notes, such as Bond Anticipation Notes (BANs), are issued in anticipation of future bond sales that will repay the notes.⁴ The market for municipal notes, while smaller than the long-term bond market, plays a crucial role in providing liquidity and bridging financing gaps for public projects and operational expenses.

Key Takeaways

• Municipal notes are short-term debt instruments issued by state and local governments.
• They typically have maturities ranging from a few months to three years.
• Proceeds from municipal notes are often used for temporary cash flow management or interim project funding.
• Interest earned on many municipal notes is exempt from federal and, often, state and local taxes for in-state residents.
• Common types include Bond Anticipation Notes (BANs), Revenue Anticipation Notes (RANs), and Tax Anticipation Notes (TANs).

Formula and Calculation

The principal and interest rate on municipal notes can be structured in various ways. Some notes, particularly those issued at a discount, do not have a stated coupon rate but are sold below their face value and mature at par. The return for an investor is the difference between the purchase price and the face value received at the maturity date.

For a municipal note issued at a discount, the approximate yield to maturity can be calculated using a simple discount yield formula:

Where:

• Face Value = The par value of the municipal note, typically paid at maturity.
• Purchase Price = The price at which the investor buys the note.
• Days to Maturity = The number of days remaining until the note matures.

Alternatively, for notes that pay interest at maturity, the total return would be the accrued interest plus the return of principal. The yield on municipal notes is influenced by factors such as market interest rates, the issuer's creditworthiness, and the notes' tax status.

Interpreting Municipal Notes

Interpreting municipal notes involves assessing their short-term financial implications for both issuers and investors. For issuers, the decision to use municipal notes often reflects a need for immediate capital that can be quickly repaid, or a bridge to longer-term debt financing. The cost of borrowing, which is the interest rate or discount yield, reflects the market's assessment of the issuer's credit risk over the short term. A lower yield generally indicates higher credit quality or strong market demand.

For investors, the primary appeal of municipal notes typically lies in their tax advantages and short duration, which can offer a degree of capital preservation and predictable income. The interpretation centers on the net yield after taxes, comparing it to other short-term investment options. Given their shorter maturities, municipal notes tend to have less interest rate sensitivity than long-term bonds, meaning their market value is less volatile in response to interest rate fluctuations.

Hypothetical Example

Consider a local school district that needs $10 million to cover immediate operational expenses until property tax revenues are collected in six months. Instead of issuing long-term bonds, the district decides to issue $10 million in Tax Anticipation Notes (TANs).

The TANs are issued with a face value of $5,000 each and a maturity of six months. To attract investors, they are offered at a discount. An investor purchases one TAN for $4,950.

At the end of six months (approximately 180 days), the school district repays the investor the full face value of $5,000.

The investor's gain is:
$5,000 (Face Value) - $4,950 (Purchase Price) = $50

To calculate the approximate annualized discount yield:

In this example, the investor earns a 2% annualized yield on their investment. If the investor is in a high tax bracket and the interest is both federally and locally tax-exempt, the after-tax return could be significantly higher than a comparable taxable investment. This scenario illustrates how municipal notes provide a flexible debt financing solution for public entities.

Practical Applications

Municipal notes serve several practical applications in public finance and investment portfolios:

• Cash Flow Management: State and local governments often face uneven revenue collection and expenditure cycles. Municipal notes, particularly Tax Anticipation Notes (TANs) and Revenue Anticipation Notes (RANs), provide essential working capital to bridge these gaps, ensuring the smooth operation of public services.
• Bridge Financing: Bond Anticipation Notes (BANs) are a common use case, allowing municipalities to begin projects (e.g., school construction, road repairs) before securing long-term municipal bond financing. Once the long-term bonds are issued in the primary market, the proceeds are used to retire the BANs.
• Investment for Liquidity: For institutional and individual investors seeking short-term, relatively safe, and potentially tax-exempt investment options, municipal notes offer a degree of liquidity. They can be attractive alternatives to money market instruments or certificates of deposit for those in higher tax brackets.
• Federal Reserve and Monetary Policy: While not directly targeted, the market for municipal notes is indirectly affected by broader monetary policy decisions by institutions like the Federal Reserve. For instance, changes in the federal funds rate can influence short-term borrowing costs for municipalities and affect the attractiveness of municipal notes relative to other short-term fixed income securities. Federal Reserve Vice Chair Michelle Bowman has often commented on economic conditions and monetary policy, which broadly influence short-term interest rates and market liquidity.³
• Underwriting and Disclosure: Financial firms acting as underwriters play a crucial role in bringing municipal notes to market. These underwriters are subject to rules set forth by bodies like the Municipal Securities Rulemaking Board (MSRB) and the Securities and Exchange Commission (SEC). SEC Rule 15c2-12, for example, requires underwriters of most new municipal securities issues to ensure the issuer commits to providing ongoing disclosure of financial information to the MSRB, enhancing transparency for investors.²

Limitations and Criticisms

While municipal notes offer benefits, they also come with limitations and potential criticisms. One primary concern relates to the issuer's credit risk. Although short-term, these notes are still subject to the financial health and management of the issuing municipality. A deterioration in the issuer's fiscal condition, unexpected budget shortfalls, or unforeseen events can impact the ability to repay the notes, leading to potential delays or defaults.

Another limitation is their relatively lower yield compared to longer-term debt, especially in low-interest-rate environments. While the tax-exempt status can enhance their appeal, the pre-tax return may not be competitive for all investors, particularly those in lower tax brackets who might find higher returns in taxable alternatives.

Furthermore, the secondary market for certain municipal notes, especially those from smaller or less frequently issuing entities, may be less liquid than for larger, more frequently traded municipal bonds. This can make it challenging for investors to sell their notes before maturity without impacting their price. The tax-exempt status of municipal debt has also been a subject of ongoing debate, with some arguing that it disproportionately benefits high-income earners or that it can be an inefficient federal subsidy to local governments.¹

Municipal Notes vs. Municipal Bonds

The primary distinction between municipal notes and municipal bonds lies in their maturity periods. Both are debt instruments issued by state and local governments.

Confusion can arise because both fall under the umbrella of municipal securities and often share the same tax-exempt status. However, their differing durations mean they serve distinct purposes for issuers and cater to different investment horizons and risk tolerances for investors. Municipal notes provide quick, temporary funding, while municipal bonds secure long-term capital for substantial public works.

FAQs

What is the main purpose of municipal notes?

The main purpose of municipal notes is to provide short-term debt financing for state and local governments. This can be for managing temporary cash flow imbalances, covering expenses until tax revenues are received, or serving as interim funding for projects before a long-term municipal bond issue is finalized.

Are municipal notes tax-exempt?

Yes, typically the interest income from municipal notes is exempt from federal income taxes. Depending on the issuing entity and the investor's state of residence, the interest may also be exempt from state and local income taxes, offering a "triple tax-exempt" benefit. This tax advantage is a key characteristic of these fixed income securities.

What are the different types of municipal notes?

Common types of municipal notes include Bond Anticipation Notes (BANs), which are issued in anticipation of future bond sales; Tax Anticipation Notes (TANs), issued in anticipation of future tax receipts; and Revenue Anticipation Notes (RANs), issued in anticipation of future non-tax revenues. There are also Grant Anticipation Notes (GANs) and Project Notes (PNs).

How do municipal notes differ from commercial paper?

While both municipal notes and commercial paper are short-term debt instruments, the key difference lies in their issuer and purpose. Commercial paper is typically issued by corporations to meet their short-term funding needs. Municipal notes, as the name suggests, are issued by governmental entities for public finance purposes and often carry unique tax exemptions not found in corporate commercial paper.