In my opinion, no asset class is driven more by public policy than municipal securities. Federal or state policy initiatives determine everything from taxes levied upon income, property, and consumer sales to the coveted tax exemption on municipal bonds. Funding priorities and competing allocations of critical, yet thinning, resources for infrastructure and other essential purpose projects are decided by policy choices.
When we discuss the many ways municipal bonds support our nation's economy, governmental purpose evokes an intuitive understanding. However, private activity is a commonly used concept across the public finance ecosystem that is often misunderstood.
It is virtually impossible to think about private activity without considering it within the context of private-activity bonds and individual state private-activity bond volume caps. Without getting too entrenched in the technical weeds, I would like to provide a straightforward narrative on how the private-activity bond volume cap stands at the intersection of federal tax policy and state and local decision-making for economic development.
On a very basic level, private activity along with volume cap mechanics remain rooted in the public policy discussion, and recognizing their significance can enable market participants to gain insight into legislative strategy and priorities when it comes to the use of tax-exempt financing. This knowledge can assist issuers and their advisors with developing a debt management plan designed to not only maximize the use of tax exemption, but to prioritize and leverage the tools available to meet infrastructure and other capital needs.
Examples of private-activity bonds include those issued for multifamily affordable housing, single-family mortgages, airports, most student housing facilities, and solid waste projects. A review of a deal's official statement and the legal/tax opinions provides clarity on use of proceeds and alternative minimum tax (AMT) exposure, which will be discussed later. Private-activity bonds are typically subject to state volume caps, but there are certain category exemptions of private-activity projects that are excluded from the cap — a fact sometimes lost in nuance.
Much of today's modern public finance framework can be traced back to the Tax Reform Act of 1986 (the Act). The Act formalized the definition and created a statutory category of "Qualified Private Activity" bonds in the Internal Revenue Code — thus establishing eligibility standards for tax-exemption — and placed state volume caps on private-activity debt issuance for allocation purposes. Importantly, private-activity bonds existed prior to the Act, but the old framework was widely fragmented.
Private activity unpacked
Let's take a step back and think about why there is a distinction between governmental purpose and private activity. In a traditional sense, governmental purpose municipal bonds are tax-exempt securities issued to finance core essential public infrastructure and governmental projects owned and operated by state or local governments.
Governmental purpose bonds account for the majority of tax-exempt issuance with a wide-ranging scope including schools, water and sewer systems, bridges, tunnels and roads. Private businesses accrue no financial benefit and debt repayment is not backed in whole or in part by a privately derived revenue stream.
Unlike governmental purpose bonds, which are not subject to volume caps, private-activity bond qualification must test for private use of proceeds and security repayment. Projects financed with private-activity bonds capture private entity participation, but nevertheless receive a congressional opinion that they provide an important public benefit.
The private use test requires that more than 10% of bond proceeds be used for a private business purpose, such as for-profit corporations and partnerships and LLCs. The private security test requires that over 10% of debt service is secured by 1) property used in a private business or payments from such property, or 2) payments made by a private business user.
The key is to determine the ultimate party responsible for debt service. As examples, an airport terminal leased to a commercial airline where lease payments secure debt service, and a hospital issuing bonds through a conduit issuer, with debt service backed by the hospital, likely satisfy these tests.
Private-activity bonds are generally subject to federal taxation unless they are eligible for an exclusion under "Qualified Private Activity." Since passage of the Act, Congress has amended the list of "Qualified Private Activity" bonds multiple times. Initial "Qualified Private Activity" bond categories included exempt facility bonds (such as airports), qualified mortgage bonds, qualified veterans' mortgage bonds, qualified small-issue industrial development bonds, and qualified student loan bonds. Authorization for qualified redevelopment bonds has been repealed.
Qualified 501(c)(3) bonds issued on behalf of nonprofit organizations — such as nonprofit hospitals, universities and private colleges — were given exempt private-activity status by the Act and are therefore federally tax-exempt and not subject to state volume caps even though they are not treated as governmental purposes. Qualified 501(c)(3) bonds represent one of the largest sectors of the tax-exempt market. The "Qualified Private Activity" designation also extended to residential rental project bonds and public educational facility bonds.
Analysis of student housing revenue bonds must be given careful consideration, as these bonds are often sold under varying legal and tax structures, with certain types of student housing bonds considered governmental purpose bonds. In such cases, a public university usually owns and operates the student housing facility with little to no private benefit and the housing projects are financed by the university or a state authority.
Other types of student housing financings, however, could involve qualified 501(c)(3) bonds issued for nonprofit colleges and universities, thus labeled private activity. Certain P3 student housing bonds often utilize relatively complex private-activity structures.
State volume caps create a powerful mechanism
State volume caps were created by Congress in direct response to heavy issuance of tax-exempt debt for projects that accrued benefit to private entities during the late 1970s and early 1980s and the associated growth in federal tax expenditures. The volume cap serves as (1) a consequential capital allocation tool that aligns private capital with public policy priorities and (2) an arbiter of which projects have access to tax-exempt financing.
Volume caps effectively limit the use of tax-exemption — and therefore reduce the revenue loss to Treasury — for those projects benefiting private entities and prioritize state resource allocations for competing public policy initiatives. After an initial imposition of a nationwide volume cap in 1984 (through the Deficit Reduction Act of 1984), the Act (1986) instituted fundamental changes to the volume cap framework, including the expansion of bonds subject to the cap (such as housing-related bonds) and revisions to state allocation methodology and carryforward rules.
Competition for the volume cap can sway issuer financing opportunities and their municipal advisors and bond counsel can help with the strategic and compliance aspects of the volume cap process. For institutional investors, understanding the distinctions between governmental purpose and private activity and how volume cap mechanics work can add strategic guidance in support of portfolio construction. This is relevant for diversification, tax efficiency, performance attribution, supply dynamics, credit analysis, relative value opportunities, liquidity, regulatory considerations, duration management and investment suitability.
The significance of the private-activity volume cap should not be underestimated, as targeted priorities extend beyond infrastructure investment to include affordable housing, environmental facilities, cyber and disaster resiliency and other public-purpose recipients.
A private-activity bond is not counted against a state's volume cap in the case of exempt projects, even though the associated projects satisfy the private use and security tests under Internal Revenue Service codes. For example, most federally designated qualified private-activity general aviation revenue bonds are excluded from the volume cap and therefore do not need to compete for limited volume cap allocations.
Although airports are typically owned and/or operated by a municipal government or enterprise unit thereof, there is beneficial interest that accrues to private parties, such as commercial airlines, car rental agencies and concessionaires.
However, the significant contributions made by bonds issued for airport infrastructure are invaluable to the nation's transportation network and are, therefore, granted allocation-exempt status as opposed to being volume cap dependent. For these reasons, airports remain a significant recipient of tax-exempt capital and public ownership of a project does not exclusively determine designation of governmental purpose or private activity.
I would note that municipal bonds issued to finance consolidated rental car facilities (CONRACs) at airports are typically labeled as "Qualified Private Activity" bonds, and are usually exempt from state volume caps. In their analysis, Congress and the IRS link CONRAC facilities to integral airport operations, thus allowing exempt designation. While the primary users are private rental car companies, the facility is owned by a municipal government or enterprise unit thereof.
Under the Act, most "Qualified Private Activity" bonds were linked to volume caps. Congress made a clear distinction between private benefit and public purpose by using the volume cap as a policy tool for allocating federal tax subsidies to those private activities most in need.
Nonprofit hospitals are somewhat unique in that they enjoy 501(c)(3) status and are exempt from volume caps. However, they provide a certain amount of charity care within their communities, a necessary attribute to preserve the tax-exemption on interest income. I note that a pending bill would exempt multi-family mortgage revenue bonds from the private-activity bond volume cap. States like California could benefit by financing multi-family mortgage revenue bonds outside of the cap. This exemption for multi-family housing is long overdue.
Volume cap allocations are determined each year, set by a federally imposed state ceiling and bound by the greater of a per-capita amount or a small-state minimum. The IRS annually publishes the inflation-adjusted amounts. Once the states receive the allocation, each state allocation agency distributes the cap authorization based on priority and need. At this point, allocations are made available to issuers.
For calendar year 2026, the private-activity bond volume cap is the greater of $135 per resident or $397,625,000. A state by state view into the allocations reveals an interesting observation. Thirty-three states receive their allocation based on population and seventeen states receive their allocation based on a statutory minimum of $397,625,000. About one-third of the states - those with the smallest populations - are not reliant upon per capita allocations and are insulated from population shifts.
The basis allocation demonstrates that Congress did not want to give the largest states a disproportionate advantage. In actuality, however, many small states have more financing capacity on a per-capita basis. With the minimum allocation, smaller states can receive an "X" multiple cap allocation of what the per capita formula would provide. Without the minimum, many rural states would not have sufficient allocation in support of critical economic development. Under this arrangement, small states are not left behind.
Unused allocations may be subject to carryforward, but an eligible purpose must be designated. Such purposes can include residential rental housing, student loans, and qualified mortgages. Current rules allow carryforward for three years.
AMT is less relevant to investment strategies
The Act also included interest income on private-activity municipal bonds as a tax preference item for AMT calculations. This specific provision applies to "Qualified Private Activity" bonds issued after August 7, 1986, and requires that tax-exempt interest earned on these bonds be added back to taxable income when determining AMT exposure.
Historically, many private-activity bonds — including airport, certain student loan, and many exempt facility bonds — generated interest income that was a preference item for AMT calculations. Not every private-activity bond, however, was subject to the AMT, such as qualified 501(c)(3) private-activity bonds. Note that interest income earned on taxable municipal bonds is not subject to AMT consideration.
The Tax Cuts and Jobs Act of 2017 (and subsequent legislation) greatly transformed the AMT landscape through significant dilution of AMT exposure. For "Qualified Private Activity" bonds issued after December 31, 2017, this act repealed the old corporate AMT and eliminated the individual AMT preference item for interest income. Qualified private-activity bonds issued before January 1, 2018, may still have AMT exposure.
The Inflation Reduction Act of 2022 introduced a corporate AMT effective for tax years beginning after December 31, 2022. A 15% AMT rate now applies to very large corporations reporting average annual adjusted financial statement income exceeding $1 billion over a three-year testing period.
The tax is largely based on book income with many adjustments, rather than taxable income. Therefore, corporate demand for municipal securities is considerably less influenced by AMT considerations.
Before implementation of the 2017 Tax Act, many retail investors avoided AMT bonds, given active movement between AMT and non-AMT exposure, despite higher available yields on AMT paper. Note that interest income on tax-exempt bonds is not the only preference item for AMT calculation purposes.
While the 2017 legislation altered the AMT backdrop, associated bonds retain their private-activity label. Suffice to say, investment considerations between governmental purpose and private activity have largely shifted to credit attributes from tax efficiency. Today, only a relatively small percentage of high-income households have AMT exposure.
Investment guidelines for many SMA portfolios may still require identification of bonds subject to AMT for disclosure or avoidance purposes. Against this backdrop, the market extracts a smaller yield premium as compared to 20 years ago. However, legacy AMT bonds may exhibit trading distinctions, given technical factors and investor preferences.
To keep this discussion in proper context, let me clearly state that private-activity bonds, volume cap bonds and AMT bonds each should be viewed through a separate lens. Although they are related, they do not convey the same concept and I caution market professionals against conflating the three. Importantly, the volume cap rules and AMT provisions are separate elements of the tax code.
Moving along this sobering path of tax and legal terminology, it should be quite evident that the market can relax its focus on these considerations. In my opinion, it is more relevant today to apply stringent credit analysis to these various types of project-finance and enterprise revenue bonds that are primarily financed through private-activity bonds. This will outweigh tax exposure considerations when it comes to valuations, performance and liquidity.
This approach will also help to strike an appropriate balance when it comes to portfolio allocations between governmental purpose general obligation bonds, and myriad revenue bonds. These two broad classifications of bonds take on different risk attributes throughout the economic cycle. Certain private-activity bonds, such as for hospitals and airports, may see their economically sensitive revenue streams exposed to wider fluctuations.
Given their mandates for regulatory reporting and statutory capital and liquidity requirements, banks and insurance companies will continue to hold governmental purpose bonds and private-activity bonds to different analytical standards. One clear distinction is the lack of taxing authority for private-activity bonds, which are typically reliant upon project economics. Herein lies potential opportunities when pricing anomalies present themselves.
