The Basics Of Municipal Bonds

Some investors look for investments that produce current income rather than seeking growth-oriented securities. Typically, these people are retirees, or they are trying to diversify their portfolios. Municipal bonds (also called munis) are popular choices. Munis provide regular interest income. In addition, many offer tax advantages and low risk.

If you are interested in learning about income-producing investments, this article will get you started by explaining what munis are. Moreover, you’ll discover how to evaluate a bond based on its interest rate, tax features, and risk. For further information, check out the investor education website maintained by the Securities Industry Financial Markets Association (SIFMA).

What are Municipal Bonds?

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A municipal bond is a debt security. State and local governments issue these bonds in order to borrow money. Municipal bonds usually have a face value of $5,000. Also called par value, this is the amount that the borrowing government must pay to retire the debt when the bond matures. A municipal bond can mature in a few weeks, or it may have a maturity of 30 years or longer.

Municipal bonds pay a fixed amount of interest each year called the coupon. For example, a $5,000 bond might have an annual coupon of $200 per year. This converts to a percentage interest rate of 4 percent, which we call the coupon rate. Interest on a municipal bond usually does not accrue. Instead, interest is paid to bond owners semiannually.

Obligation bond and revenue bond

It may be either a general obligation bond or a revenue bond. General obligation bonds are secured by the full faith and credit of the government that issued them. In other words, the government pledges to pay for the bond using its tax and other revenue sources. General obligation bonds typically fund public works like schools, roads, and hospitals. A revenue bond is secured by future income from the project the bond funds, such as a sports stadium or public/private business venture.

An In-Depth Look at Municipal Bonds – Interest, Price and Yield

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A key parameter for the investor that considers a municipal bond is the effective interest rate, known as the yield. Yield is not the same as the coupon rate. Like corporate and Treasury bonds, a municipal bond trades on the bond market. As a bond is bought and sold, the price rises and falls in response to market conditions, the risk the bond carries and other factors.

Calculation of a yield is the following. Divide the annual coupon by the price of the bond. Multiply the result by 100 to convert to a percentage rate. Suppose a municipal bond with a $200 coupon is selling for $4,500. Divide $200 by $4,500. Multiply by 100. The yield works out to 4.44 percent.

As you can see, the yield is important because it is the yield, and not the coupon rate, that determines the actual interest rate you get when you invest in a bond. Price is important in another way. When you redeem a municipal bond, the issuer must pay you the face value. If you purchased the bond at a discount below the face value, you realize a capital gain at redemption. If the bond was bought at a premium (above face value), it results in a loss.

Evaluating the Tax Benefits of Municipal Bonds

Investors have a big interest for the tax exemptions a municipal bond may offer. Municipal bonds usually have a lower yield than comparable corporate bonds. However, tax breaks can more than make up the difference.

Municipal bonds may be exempt from federal income tax, state income tax or both. For interest to qualify for exempt status under federal law, the issuing government must use the borrowed money for a purpose that represents a benefit to the general public. For example, a municipal bond sold to finance a school or road would qualify. A bond issue used to pay for a new sports stadium would not qualify. States typically make interest on munis issued by a government within the state exempt from state income tax.

Side note:

The tax breaks that come with a municipal bond do not apply to any capital gain realized from its redemption or sale. This means you must pay capital gains tax on any such profit. Only the interest can be tax-exempt.

Suppose you are considering purchasing either a tax-free municipal bond or a corporate bond. All else being equal, the bond with the greater after-tax income is the better deal. To figure out which bond is best, compute the tax-equivalent yield. First, subtract your marginal tax rate from 1. Include both state and federal income tax rates if the bond interest is exempt from both. Divide the municipal bond yield by the result to find the tax-equivalent yield. If the answer is greater than the corporate bond yield, the muni will pay more after-tax interest.

Example of a Municipal Bond and Its Benefit

Here’s an example. A municipal bond has a yield of 4.44 percent and a corporate bond pays 6 percent. The muni interest is exempt from state and federal income taxes. Your marginal tax rate (the maximum percentage tax you pay on income) equals 35 percent. Subtract 0.35 from 1. Divide the municipal bond yield by the result of 0.65. The tax-equivalent yield in this example works out to 6.84 percent, so the municipal bond is the better deal.

Primary Risks of Municipal Bonds – Interest Rate Risk and Credit Risk

There are two important investment risks when it comes to municipal bonds: interest rate risk and credit risk. Interest rate risk refers to the fact that prevailing interest rates could go up in the future. If this happens, the bond price usually falls to compensate. An investor must then choose between two options. Either selling at a loss or settling for a below-market interest rate.

A municipal bond also carries credit risk. Credit risk refers to the chance that a municipal government could run into financial trouble. It could default on the bond. However, this is a rare occurrence with a municipal bond. For the individual investor, the best way to assess credit risk is to check the bond’s rating by bond rating services. The safest bonds have an AAA rating. Lower ratings mean more risk of default, but the bonds usually have higher yields to offset the added risk.

Conclusion

State and local government entities use municipal bond issues to finance a variety of projects or to cover current expenses. A municipal bond features competitive interest rates, low risk, and a steady income stream. These characteristics make municipal bonds a popular choice for retirees and people who want to diversify investment portfolios. A municipal bond is even more attractive when it comes with tax advantages.

Comments are welcome. You are invited to ask questions about this article and to make suggestions. This will help improve this article and suggest topics for the future. If you have ever purchased a municipal bond, please share your experience with other readers. Your insights can help others make wiser investment decisions.