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Municipal bonds, or "munis" for short, are IOU's issued by city, county, and state governments in order to raise money for community projects [such as a highway, new school, or hospital]. Their primary attraction is that the interest paid to the owner of a municipal bond is exempt from federal taxes. In most cases, if the investor resides in the state the bonds were issued in, he / she maybe exempt from state and local taxes as well.
General Obligation vs. Revenue Bonds
There are two types of municipal bonds available. The first are
called General Obligation [GO for short], and are backed by issuer's ability to
tax. General obligation bonds are issued to pay for schools, sewer
systems, etc. Most investors consider them safer, although this is a
misconception.
Revenue munis, on the other hand, are issued by special state or local-government sanctioned entities [such as a utility company]. The interest is paid based on the revenue of the business that backs it. In the case of a water company, bond holders are paid out of the profit generated from customers paying their water bills.
Tax-Free
Munis vs. Taxable Equivalent Yield
If you are an
average investor interested in bonds, you may have a difficult time deciding
between purchasing fully-taxable corporate bonds or tax-free municipals.
Using a formula called taxable equivalent yield, you should be able to decide
which type of fixed income investment will provide you the greatest after-tax
return. Here's the formula you should use:
tax exempt yield
-------(divided by)--------
1 - tax bracket
Let's look at an example. If you were interested in purchasing a municipal bond that paid 5% interest, and you were in the 15% tax bracket, you would plug your information into the formula:
.05 (tax exempt yield)
-------(divided by)--------
.85 [1 - .15 = .85]
The answer is 0.0588, or 5.88%. This means that if you could find a fully-taxable bond with a yield greater than 5.88%, you would earn more on your money by purchasing it than the tax-free municipal. If corporate bonds are paying an average of 8%, you would be a fool to invest in municipals.
Gauging the
safety of municipal bonds
There is very little information available concerning individual
municipal bonds. This forces investors to rely heavily on the credit
ratings assigned by various credit agencies. To help ensure the safety of
their investment, bondholders should find out 1.) who is responsible for
servicing [aka "paying"] the interest payments on the bonds, and 2.) what are
the underlying economics of the issuer. Is it a blossoming community with
a growing, high-net worth citizen base, or a deteriorating metropolis with
lower-income demographics? All of these factors should be of concern.
More
information
For more
information, check out "The Bond Book" by Annette Thau [
].
The book is aimed at those that have little or no bond experience and covers
virtually everything an investor needs to know.
Copyright © 2002 Joshua Kennon