WHAT ARE MUNICIPAL BONDS?

Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities to raise money to build schools, highways, hospitals and sewer systems, as well as many other projects for the public good.

When you purchase a municipal bond, you are lending money to an issuer who promises to pay you a specified amount of interest (usually paid semiannually) and return the principal to you on a specific maturity date.

Not all municipal bonds offer income exempt from both federal and state taxes. There is an entirely separate market of municipal issues that are taxable at the federal level, but still offer a state - and often local - tax exemption on interest paid to residents of the state of issuance. Most of this booklet refers to munis which are free of federal taxes.

Taxable municipal bonds exist because the federal government will not subsidize the financing of certain activities which do not provide a significant benefit to the public at large. Investor-led housing, local sports facilities, refunding of a refunded issue and borrowing to replenish a municipality's underfunded pension plan are just four types of bond issues that are federally taxable. Taxable municipals offer yields more comparable to those of other taxable sectors, such as corporates or agencies, than to those of other municipals. The growth of the taxable municipal market in recent years has been astounding. In the last five years alone, over $90 billion in taxable municipals has been issued.

Tax-exempt municipal bonds are among the most popular types of investments available today, and with good reason. They offer a wide range of benefits, including:

• Attractive current income free from federal and, in some cases, state and local taxes;
• High degree of safety with regard to payment of interest and repayment of principal;
• Predictable stream of income;
• Wide range of choices to fit in with your investment objectives with regard to investment quality, maturity, choice of issuer, type of bond and geographical location; and
• Marketability in the event you must sell before maturity.

Generally, bonds rated BBB or Baa, or better, by Standard & Poor's and Fitch, or Moody's, respectively, are considered "Investment Grade," suitable for preservation of investment capital.
CREDIT RATINGS CREDIT RISK MOODY'S STANDARD & POOR'S FITCH PRIME Aaa AAA AAA EXCELLENT Aa AA AA UPPER MEDIUM A A A LOWER MEDIUM Baa BBB BBB SPECULATIVE Ba BB BB VERY SPECULATIVE B, Caa B, CCC, CC B, CCC, CC, C DEFAULT CA, C D DDD, DD, D
Credit ratings, however, should not be the sole basis for any investment decision. For example, the ratings do not take into account market trends. Before purchasing bonds with lower ratings, talk with your investment advisor to make sure they're suited for you. Tax-exempt municipal bonds offer you the chance to maximize your after-tax return consistent with the amount of risk you're willing to accept. In general, as with any fixed-income investment, the higher the yield, the higher the risk. You may generate capital gains on a tax-exempt security if you sell it at a profit in the secondary market before it matures. Long-term capital gains (which require a 12-month holding period) resulting from the sale of tax-exempt municipal bonds are taxed at a maximum rate of 15% for all sales on and after May 6, 2003. Of course, if you sell your security for less than your original purchase price, you may incur a capital loss. Under current law, up to $3,000 of net capital losses can be used annually to reduce ordinary income. Capital losses can be used without limit to reduce capital gains. Special rules apply to a tax-exempt bond purchased at a premium or a discount and called or sold before maturity. Municipal securities consist of both long- and short-term issues. Short-term securities, often called notes, typically mature in a year or less, while long-term securities, commonly known as bonds, typically mature in more than a year. Short-term notes are used by an issuer to raise money in anticipation of future revenues such as taxes, state or federal aid payments, and bond proceeds, and to cover irregular cash flows, meet unanticipated deficits and raise immediate capital for projects until long-term financing can be arranged. Bonds are usually sold to finance capital projects over the longer term. The two basic types of municipal securities are: General obligation bonds. Principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer's unlimited or limited taxing power. General obligation bonds are also voter-approved. Revenue bonds. Principal and interest are secured by revenues derived from tolls, charges or rents paid by users of the facility built with the proceeds of the bond issue. Public projects financed by revenue bonds include toll roads, bridges, airports, water and sewage treatment facilities, hospitals and housing for the poor. Many of these bonds are issued by special authorities created for the purpose. Interest payments. Bond interest is usually paid semiannually. On notes, interest is typically paid at maturity. Form of issuance. Since July 1983, as a result of federal tax law changes, municipal bonds have been issued in registered form only. With a registered security, your name is registered on the issuer's books and appears on the bond. A growing number of municipal bonds today are issued in "book-entry" form - similar to the way U.S. government securities are issued. Ownership is recorded through data entry at a central clearing house. Your confirmation of purchase from your bank or investment firm provides you with a written record of the transaction. With book-entry securities, physical transfer of certificates is not necessary. Registered and book-entry bonds offer a number of protections and conveniences to bondholders including protection from loss or theft, automatic payment of interest, notification of calls, and ease of transfer, among others. Before July 1983, municipal securities were issued for the most part in certificate form with coupons attached. Some of these so-called "bearer bonds" are still available in the marketplace. The issuer has no record of who owns these bonds. The owner clips the coupons and collects the interest from the issuer's paying agent. Transferring the bonds requires physical delivery and payment. Reporting requirements. All tax-exempt interest must be reported on tax returns. This is simply a reporting requirement and does not affect the tax-exempt status of the security. Minimum investment. Most tax-exempt municipal bonds are issued in denominations of $5,000 or integral multiples of $5,000. Most notes are also available with a minimum denomination of $5,000. Payment terms. Dealers are required by the Securities and Exchange Commission to have payment for a securities purchase and to make payment for a securities sale no later than the third business day following the date of the trade. Where to find listed prices. Financial newspapers and business pages of major daily newspapers usually list prices of widely traded municipal securities. Additionally, you can find information on the Internet through various individual investor Web sites. Because the prices are typically based on $1 million lots and reflect a volume discount, purchases and sales of smaller amounts may differ according to the size of the order. You can also receive price quotes from a municipal securities broker-dealer. Marketability. Holders of municipal securities can sell their notes or bonds in the secondary market through one of the many banks and securities dealer firms which are registered to buy and sell municipal securities. Municipal bonds are sold in the over-the-counter market instead of on an organized exchange. If you sell your bonds prior to maturity, you will receive the current market price, which may be more or less than their original cost. What are the costs of investing in municipal bonds? Municipal securities are bought and sold between dealers and investors much like other debt instruments. Dealers trade the securities at a net cost, which includes their own spread, or profit, on the transaction. Outstanding state and local debt obligations totaled $1.87 trillion as of September 30, 2003, according to Federal Reserve estimates. The largest owners of tax-exempt securities are individuals like yourself, mutual and money market funds, property and casualty insurance companies, and commercial banks. In recent years, individual participation in tax-exempt municipal bonds has expanded significantly through investments in unit investment trusts and mutual and money market funds. GLOSSARY Advance refunding. A financing structure under which new bonds are issued to repay an outstanding bond issue prior to its first call date. Generally, the proceeds of the new issue are invested in government securities, which are placed in escrow. The interest and principal repayments on these securities are then used to repay the old issue, usually on the first call date. Current refunding. A financing structure under which the old bonds are called or mature within 90 days of the issuance of the new refunding bonds. Dated date (or issue date). The date of a bond issue from which the bondholder is entitled to receive interest, even though the bonds may actually be delivered at some other date. Extraordinary redemption. This is different from optional redemption or mandatory redemption in that it occurs under an unusual circumstance such as destruction of the facility financed. Face amount. The par value (i.e., principal or maturity value) of a security appearing on the face of the instrument. Legal opinion. An opinion concerning the validity of a securities issue with respect to statutory authority, constitutionality, procedural conformity and usually the exemption of interest from federal income taxes. The legal opinion is usually rendered by a law firm recognized as specializing in public borrowings, often referred to as "bond counsel." Swap. Simply, the sale of a block of bonds and the purchase of another block of similar market value. Swaps may be made to achieve many goals, including establishing a tax loss, upgrading credit quality, extending or shortening maturity, etc. Unit investment trust (municipal). A fixed portfolio of tax-exempt bonds sold in fractional, undivided interests.