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Municipal
Bonds
Municipal (“muni’) bonds
are debt obligations of state and local municipalities. The government
offers various tax incentives to entice civic-minded investors to purchase
these securities. Muni bonds are normally free from federal income taxes, as
well as certain state and local taxes. They offer investors a market rate
yield, a steady cash flow stream and a certain degree of security that their
principal will be returned at maturity. They are ideally suited for high
income investors, and are usually issued in denominations of $5,000.
Pricing & Tax
Equivalent Yield – Municipal bonds
have lower default rates than corporate bonds, thereby considered less
risky, and trade with lower yields. When comparing municipal bond rates with
comparable corporate rates, the muni rate needs to be grossed up by the
individual’s tax rate, to arrive at a tax equivalent yield which is
comparable to a corporate yield.
Taxes
- Not all municipal bonds are federally tax exempt. Investors need to
determine if there is an IRS or legal opinion as to the tax exempt status of
a particular bond issuance. This is usually found in the prospectus. For
state tax purposes, muni bonds are usually tax exempt only in the state
issued. If one purchases a muni bond from an out of state issuer, (a state
that he does not reside in), the income from that bond is taxable in his
home state. Municipal bonds, therefore, are more appealing if you are a high
income investor and live in the issuer’s state that has a high income tax.
Always check with your broker on the tax status before making a purchase.
Additionally, muni bond income may be subject to AMT (Alternative Minimum
Tax) payments (particularly
on industrial development bonds issued after 1986) for high income
taxpayers.
Gains or losses on bonds
sold prior to maturity are normally taxable for federal income tax purposes.
However, if the bond was originally purchased at a discount at issuance and
held to maturity, there is special tax treatment which allows for the gain
to be tax exempt for federal income tax purposes.
Types of Municipal
Bonds
·
General Obligation Bonds
– These bonds are issued to fund the working capital requirements of a
municipality or to fund a particular project, such as a school. The bonds
are unsecured and are “backed” by the full faith and credit of the issuing
municipality. The taxpayers (rateables) pay back the bondholders.
·
Revenue Bonds
– Proceeds are used to fund revenue generating projects, such as airports,
hospitals and toll roads. The repayment of principal and interest is secured
by the revenues from the project. Revenue bonds are considered more risky
than general obligation bonds, and therefore offer higher yields.
Municipal Bond
Insurance - Municipal bond
insurance is a non-cancelable credit enhancement technique which raises the
credit rating of the issuing municipalities to that of the bond insurance
company. The insurance guarantees the payment of principal and interest on
the bond if the state or municipality defaults on its debt obligations, or
if a revenue generating project fails to meet its revenue projections. The
three largest companies offering this protection are MBIA, AMBAC and FGIC.
All three have triple A ratings by Moody’s, S&P, Fitch and Duff & Phelps.
It’s a risk versus yield trade-off; the premiums paid to obtain the triple A
rating more than offset the reduction in interest expenses that will be paid
on these bonds. While investors get a stronger and less volatile security
with a better secondary resale market, the yield is lower. The insurers also
have aggressive surveillance practices, which continuously monitor the
credit worthiness of the municipalities.
Sinking Funds -
A sinking fund is a conservative technique where the issuer makes
required payments to a trustee for a certain portion of a bond issue,
thereby avoiding a big balloon payment when the bonds mature. A sinking fund
feature enhances the credit worthiness of a bond.
Refunded Municipal
Bonds - These are credit enhanced
bonds that are backed by U.S treasury bonds.
Call Feature -
The call (redemption) provision allows
the issuing municipality to repurchase the bonds before their scheduled
maturity dates. Typically, when interest rates fall, municipalities can call
the bonds. The call feature can also be detachable and sold and traded
separately from the underlying bonds.
In conclusion,
municipal bonds are ideally suited for the “buy and hold” high income
investor who resides in the issuer’s state, which has a relatively high tax
rate.
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