Municipal bond in South Africa

What it is

A bond issued by a local or regional government to pay for roads, schools, water systems and the like. They exist in many countries but are really a retail instrument only in the United States, where the interest is usually exempt from federal tax and sometimes state tax too.

That tax break is the whole calculation. A muni paying 3 percent tax free can beat a corporate bond paying 4 percent taxed, for someone in a high tax band, and be worse for someone paying little tax.

Credit quality varies far more than with national bonds. Most issuers are solid; a few cities and territories have defaulted, and the small retail market can make selling before maturity expensive.

How it works

A local authority issues bonds backed either by its general taxing power or by the revenue of a specific project.
You receive fixed interest, usually twice a year, and the face value at maturity.
Interest is often exempt from federal income tax, and from state tax if you live in the issuing state.
Most retail investors hold them through funds because single bonds trade in large lots with wide dealer markups.

The honest pros and cons

For

Tax-free interest can make a modest yield worth more than a higher taxed one.
Default rates on investment-grade issuers have historically been low.
Income is steady and the money comes back on a known date.

Against

Effectively a US-only market; elsewhere the equivalent barely exists for retail.
Individual bonds are hard to sell at a fair price; dealer markups are opaque.
Revenue bonds tied to one project carry real default risk, and a few high-profile cities have defaulted.
The tax advantage is worth little to people in low tax bands.

Getting it in South Africa

not researched

Wherever you are

Work out your marginal tax rate and compare the tax-free yield with a taxed alternative on an after-tax basis.
Prefer a fund or a large diversified holding over one bond unless you can buy in institutional lots.
Check the issuer's credit rating and whether the bond is backed by taxes or by one project's income.

Go deeper

Also called

munis, local authority bonds, state bonds

Often confused with

Government bond: A loan to a government that pays interest and returns your money on a set date, called its maturity.
Corporate bond: A loan to a company that pays interest; riskier than lending to a government because companies fail more often.