Investing Tips: Tax-Free Municipal Bonds

A quick primer on municipal bonds and their benefits to investors.

After a tumultuous ride in the stock market, you begin to think about other types of investments; ones that offer a bit more stability. For this you are willing to trade a relative reduction in potential capital gains for a possible safer return. Perhaps you could invest in a vehicle that could provide you with a modest income, free from taxation. Would it be an appropriate investment for you? Does such an investment exist? It does and it's literally right outside your door - municipal bonds and municipal bond funds.

Debt securities issued by a state or local government or governmental entity are referred to as municipal bonds. The money raised by these securities is used to build roads, schools, as well as other public projects such as stadiums and parks. When you purchase a municipal bond, you are essentially lending your state or municipality the value of the bond and, in return, they pay you interest. If you are a resident of the state issuing the bond, there is a good chance the interest will be free from all taxes; federal, state and local. The reason you wouldn't have to pay federal taxes is due to the separation of powers, where the federal government can't tax state issues, just as states cannot tax federal issues. Since you are lending the money to your state or municipality, those entities usually waive the taxes. Check with a tax professional to find out the specifics of the bonds that you are interested in since there are some instances where taxes can be levied. As a general rule, most residents of the state from whom they purchased the bond enjoy the triple tax-free status of these investments.

Because of the tax-free status of these bonds, they usually trade at a reduced rate of interest to corporate issues. In order to determine whether the interest you will receive from a municipal bond is in keeping with your desired net return, or yield, there is a simple equation to assist you. When comparing your net return from municipal bonds to corporate bonds, you must compute what is known as the "˜tax-equivalent yield'. Take your tax-free yield divided by 1- (your federal tax rate) = tax equivalent yield. As an example, say you are considering two different bonds for purchase; one, a taxable corporate bond, the other a tax-free municipal bond. The taxable corporate bond has a 5% interest rate, the tax-free municipal bond offers a 4.5% interest rate. Let's assume you are in the 25% tax bracket. To calculate what the taxable equivalent of the tax-free municipal bond yield would be, divide the tax-free rate by 1 minus your tax bracket: 4.5% divided by 1-.25 (which equals .75) = 4.5 divided by .75 = 6%. The tax-free municipal bond's tax equivalent yield of 6% is higher than the taxable investment's 5% interest rate. In other words, a taxable investment would have to pay you 6% interest in order to equal the interest you would receive from a municipal bond issue that pays 4.5% interest.

Municipal bonds come in three basic forms. First is the general obligation bond, which is backed by the full faith and credit, in the form of the municipality's taxing power, of the issuing agency. Second is the revenue bond, which is backed by the revenue generated from a specific project, authority, or agency. These bonds are not backed by the full faith and credit of the agency and are only as good as the specific projects they support. Third is the industrial development bond, or IDB, which is issued to support the purchase or construction of industrial facilities that will be leased to private businesses. The leasing fees are used to pay the interest and principal to the bondholders.

There are two ways to invest in municipal bonds. You can buy them from a broker who will likely advise you that they come in $5,000 par values and require a $25,000 minimum investment, or you can purchase them through a mutual fund. Most mutual funds require a minimum investment of $1,000 - $2,000, making them much more affordable to your average investor.

To determine which bonds are considered of a higher quality than others, Moodys and Standard & Poors have created a rating system to assist investors. The highest rated bonds, usually with their principal and interest insured by an outside private concern such as MBIAC, are given a quality rating of AAA. On the opposite side of the spectrum, the lowest rating a bond can receive is C, and is considered an extremely poor prospect. These low-rated issues should be considered only by those investors with a high level of risk tolerance, and should be avoided by conservative investors altogether.

Municipal bonds and municipal bond funds can be a great means of creating a tax-free income, particularly for those with a large tax burden. For those who purchase municipal bonds in the form of a mutual fund, the tax-free interest can be re-invested to purchase additional shares, thereby increasing the principal and, subsequently, future interest. These issues make a solid addition to a well-diversified investment plan, and represent the more conservative side of a balanced portfolio.

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