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Interest earned from municipal bonds is ordinarily federal-tax exempt. It is also state and local tax-exempt, provided that you are a resident of the issuing state (interest from bonds issued in certain territories, such as Puerto Rico are exempt in all states). The most secure municipal bonds are those with are rated triple-A by either Moody's or Standard & Poor's (or both). Many municipalities which would not otherwise be able to get the highest credit rating are insured by FSA, MBIA or Ambac in order to get triple-A ratings. Bonds with greater credit risk should carry greater yields.
Municipal
bonds can be broadly classified into two groups: general
obligation and revenue bonds. The major distinction
between the two is the manner in which they are secured
- that is, where the money will come from to pay back
the principal and interest of the loan to the bondholder.
General Obligation Bonds are issued by a governmental
unit that has the power to levy taxes. They are secured
by the issuer's unconditional promise to pay promptly
the semi-annual interest expense and principal when
due. General obligation bonds mandate the issuer to
use its ability to levy taxes for the repayment of the
bonds. They finance public improvement projects that
benefit the entire community, like streets, free-access
highways, water systems, schools, police and fire stations.
Revenue Bonds are usually issued to finance a
project or purpose that will generate income that can
be pledged for repayment of the bonds, for example,
water, sewer or electric power plants, airports, bridges,
college dormitories and housing developments. Revenue
generated by the project is used to pay the interest
and principal of the bond.
Municipal bonds,
and funds of municipal bonds (see money
market funds) and funds secured by municipal bonds
and bearing their tax characteristics (see variable
rate demand notes), can often yield taxpayers in
higher brackets significant tax attributes.
As with US Treasury Bonds, purchasing long-term municipal bonds that are near maturity in the secondary markets at a premium can provide tax losses on maturity, a positive tax attribute that can offset gains that you may have.
At the moment, tax-free money market funds and variable rate demand notes often have have yields that are equivalent to fully taxable rates in excess of 5.00%.
In order to determine the taxable equivalent of a tax-free municipal, divide the tax-free rate by the reciprocal of your cumulative federal and state tax obligations.
(Tax-free municipal rate) / (1 - Your federal tax rate - your state tax rate)
Compare fully taxable equivalent to a municipal bond.
What to Look for:
The
market for municipal bonds differs from state to state
depending on the state's tax rate (high state and local
taxes would tend to drive down municipal yields since
they drive up taxible equivalents), demand within the
state and supply. Therefore, it is always necessary
to look at your state's market for municipals. The Bond
Market Association produces a real-time ticker that
shows where municipal bonds are trading at any given
moment. See
it here.
Avoiding Pitfalls:
Always be certain that interest produced by your municipal bond is free of federal, state and local taxes before you purchase.
Avoid investing in municipal bonds where you cannot fully utilize the tax benefits (ie. municipals of other states). Avoid municipals altogether if you live in a state without income tax or outside the US.
Long
dated municipals will suffer a more pronounced decline
in value in a rising interest rate environment than
Treasuries as the supply is always more limited.
