Municipal Convertible

A municipal convertible is a type of zero-coupon bond that becomes a standard interest-bearing bond after a prescribed period of time.

A municipal convertible is a zero-coupon convertible issued by a municipal government. When a bond hits its maturity date, investors receive the full face value of the bond. Standard bonds yield returns above the face value of the bond because investors receive regular coupon payments, representing interest on the underlying loan. As their name implies, zero-coupon bonds do not yield any coupon payments. Investor returns on zero-coupon bonds instead come from the difference between the initial bond price and the face value of the bond at maturity, known as the original issue discount.

When a convertible bond reaches its conversion date, the zero-coupon bond becomes a standard, interest-yielding bond with the same face value. The U.S. Internal Revenue Service (IRS) generally exempts interest payments made on municipal bonds from taxation. The IRS typically considers the original issue discount on a municipal convertible to be interest income, offering an additional benefit to investors in this type of bond.

Issuers offer a variety of municipal convertibles, mostly distinguishable by the way issuers account for the debt. For example, capital appreciation bonds (CABs) invest the initial principal at a specific rate and pay gains to investors as a lump sum at maturity, where a straight zero-coupon bond defers payment of the original issue discount amount until maturity. In either of these cases, investors receive an established return on an established date, relieving them of potential reinvestment risk if interest rates decline during the initial maturity period. From the issuer’s standpoint, however, the total par value of a zero-coupon bond counts against the municipality’s statutory debt limit, whereas with a CAB the purchase price gets treated as the initial principal amount of the bond, leaving additional headroom with regard to statutory debt restrictions.

Municipal convertibles essentially act like two separate bond transactions bundled together. Investors who benefit from municipal convertibles usually have to match long-term funding needs to a future event, as in the case of retirement income or future college tuition payments for a child. In general, the longer before the conversion date, the more of a discount the investor receives. This allows an investor to lock in an income stream on a specific amount of principal at a future date with a smaller current cash outlay. Note that the returns on such an investment are back-end weighted. Investors only receive scheduled payments after conversion and at maturity.