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 Planning

Municipal Bonds

MUNICIPAL BONDS
Municipal bonds are debt obligations of a state, territory, or possession of the United States, or any political subdivision . Municipal bonds may be issued by a variety of entities including states, counties, cities, tax districts, schools, hospitals, street and highway departments, and port authorities.  Before  the enactment of the Tax Reform Act of 1986, interest on municipal bonds was totally exempt to federal income tax, The TRA imposed restrictions on the issuance of tax exempt municipal bonds and created several categories of bonds, each with distinct tax consequences to investors. Municipal bonds issued prior to the 1986 legislation, and many of those issued since the legislation, will continue to benefit from tax exempt status. The interest on certain issues becomes taxable to certain investors,  Under normal circumstances a state does not tax its own issue of municipal bond.  Municipal bonds may carry a lower rate of interest than taxable bonds of similar quality and safety.  However, much of the appeal of investing in municipal bonds stems from the fact that the after tax yield from these bonds can be superior to the yield from a bond that pays a higher rate of taxable interest.

                             TAX EQUIVALENT YIELD FORMULA

An investor is in the 30% tax bracket . A municipal bond currently yields 7%  to offer an equivalent yield a corporate bond yield can be computed as follows
7% / (divided) (10% - 30% ) = 10%


TYPE OF MUNICIPAL BONDS

There are different categories of municipal bonds.
Here are some examples:

 General obligation bonds: The principal and interest on general obligation bonds are backed by the full faith, credit, and taxing power of the issuer.  These are the safest type of municipal bonds and, consequently, the yield may be lower than on other types.

 Limited tax bonds: Limited tax bonds are the same as general obligation bonds, except the municipality has placed a limit on the taxing power that may be used to obtain funds for paying principal and interest on the bonds.

 Special assessment bonds: These bonds are issued to pay for the improvement of facilities. The principal and interest on these bonds is paid over a period of years by assessing the property owners who directly benefited from the improvements.

 Revenue bonds: Principal and interest on revenue bonds are paid from the income generated by the facility constructed with the proceeds of the bonds. These facilities might include toll roads, bridges, tunnels, or airports.

Municipal bonds have two principal risks: interest rate fluctuations and default by the issuing municipality. The value of existing municipal bonds fluctuates with the rise and fall of interest rates.  If interest rates increase, the value of the bonds will decrease. If interest rates go down, the value of the bonds will increase. An investor is assured of receiving face value for a bond only if it is held until it matures, or until it is called by the issuer.

PRE REFUNDED
Pre refunded municipals and escrowed municipals are considered safer than comparable municipals that are not pre refunded or escrowed. Pre refunded municipals are generally high coupon bonds selling at a premium that a municipality has "advance refunded" by purchasing U.S. Treasury Securities tailored exactly to meet interest and principal requirements on the bonds. Escrowed municipals are generally low coupon bonds selling at a discount for which a municipality has "escrowed" the amount needed at maturity to pay off the bonds by placing U.S. Treasury Bonds in an escrow account.

RISK OF DEFAULT
The risk of default is generally considered small on municipal bonds but there have, in fact, been major defaults in recent years. ( orange County in California was a well publicized case)  Thus, bond ratings are an important factor to consider before purchasing municipal bonds.

BOND RATING
In the United States ,rating agencies include MOODYs Investors Service, Standard & Poors Corporation.  Fitch IBCA and Duff & Phelps Credit Rating Co (DCR).  Each of these agencies assigns its rating s based on in depth  analysis of the issuers financial condition and management economic and debt characteristics and the specific revenue sources securing the bond.
 

NOT INVESTMENT GRADE

BOND INSURANCE
Insuring municipal bonds is a relatively new trend fueled by the desire of investors for additional assurance about the safety of their investments. The issuing municipality requests and pays for the insurance but bondholders ultimately pay the cost by receiving lower yields. Insured bonds usually yield one tenth to one half of a percentage point less than comparable uninsured bonds. An insured triple A (AAA) bond often trades closer to the price of a double A (AA) bond than it does to a bond which is rated triple A (AAA) without insurance. Is the insurance worth the cost? Many believe the insurance is superfluous. Others believe the extra peace of mind is worth the cost.
The minimum denomination issued for tax exempt bonds is $5,000. There is an active secondary market for these bonds which are traded over the counter, Small
denominations have less marketability than large ones and trading in many issues is very thin. This means that the securities can be sold but the spread between bid and ask price can be substantial.

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