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Benefits of Municipal Bonds

August 14, 2014

Collect interest tax free with a municipal bond (muni).

Looking to acquire interest at a tax free rate? Municipal bonds or "munis" are attractive to high income investors for this reason. Munis are debt obligations distributed by cities, counties, states, and other governmental units to private investors and are used to purchase services for the public, including schools, highways, and hospitals. These bonds are exempt from federal taxes and the majority of state and local taxes.

How does a municipal bond work?

Municipal bonds are usually purchased by banks and broker-dealers who then resell these bonds to high net worth individuals and corporations. The investors then become lenders to the issuer and in turn,collect periodic payments of interest on the bonds. The principal is typically returned when either the bonds are called by the issuer or their maturity date.

Should I invest in a municipal bond?

Keep in mind that the minimum price for most munis is $5,000 and for this reason are often only a feasible option for high net worth individuals whose income exceeds $1 million. Because munis are virtually tax free, they are particularly attractive to high net worth investors. Unlike corporate bonds, the interest you receive from a muni is exempt from federal taxes. Although corporate bonds and other taxable investments may have higher interest rates, munis often offer a higher yield in the long run. For those who fall within a high federal tax bracket, the tax break from a muni can result in a significant gain. With a muni, it could also qualify for state and local income tax exemption which would mean that you avoid having to pay income taxes altogether.

Incomes that exceed $1 million aren’t always in the highest tax brackets. In fact, many are subject to alternative minimum tax (AMT), meaning the yield on a corporate bond doesn’t have to be that much higher than a muni bond. Assume you have a taxpayer in a state with no income tax and is in the AMT. A corporate bond with a coupon of 7% would net a taxpayer the same amount as a 5.04% muni. Now assume that the taxpayer is in a state with a 5% income tax and is taxed at the highest marginal tax bracket federally (39.6%). That corporate bond with the 7% coupon only nets the taxpayer the same amount as a 3.878% muni.

Benefits

If you are an investor in a higher tax bracket, investing in a municipal bond could be advantageous for you or your company. The benefits of a muni include:

  1. Tax exemption- The primary benefit to municipal bonds is that they are free from federal tax. If you are an investor living in the state where the bond was issued, you are also exempt from state and local income taxes.
  2. Low default risk- With any type of bond, there is a risk that the bond issuer will fail to make a principal repayment or interest payment, but fortunately muni issuers have had very low default rates.
  3. Interest in local projects- The projects covered by municipal bonds could hold great meaning for you. Their projects have an impact on daily lives, and certain projects could directly concern you- whether you have a child in a new school, or are concerned with the availability of a modern and advanced hospital.

Are there different kinds of municipal bonds?

There are a number of municipal bond types but the two primary types are general obligation and revenue bonds.

  1. General Obligation (GO)- General obligation bonds do not cover a specific project. Rather, they are sponsored fully by the "full faith and credit" of the bond issuer. To make interest and principal payments, then, the issuer can use any source of revenue and if it encounters economic hurdles, it can make up for the loss by raising taxes.
  2. Revenue Bonds- Revenue bonds finance a specific project like the construction of a school or hospital. Once the project is finished, it gradually generates revenues to pay back the principal and interest on the bonds.

Any drawbacks?

There are a few risks involved in the municipal bond process, including:

  • Credit risk- The bond issuer could be plagued with economic issues that make it tough or unmanageable to fully pay interest and principal. There are credit ratings available for many bonds that estimate the credit risk of the bond compared to others, but in the end there is no way to completely predict a default.
  • Interest rate risk-Interest rates could rise, and if they do, market prices of existing bonds will decline.

Municipal bonds are not beneficial for all investors, they're better suited for investors in higher tax brackets. Consider your status as an investor and take into account the risks involved in the process. If it turns out to be a viable option for you, the financial benefits will likely be extremely favorable. For more information regarding Municipal Bonds, please contact our Private Client Services group.

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