What are municipal bonds?
A municipal bond is a pledge or a binding agreement that the issuer, usually public bodies and agencies such as states, cities, counties, school districts, governmental agencies and authorities makes to the holder of the bond to pay a fixed sum of money on a definite date, at a fixed rate of interest.
Since 1913, municipal bonds have offered a tax-free source for your investment dollars. Not only do they provide attractive benefits for the individual investor, but tax-free bonds raise the funds necessary to build essential public projects such as schools, bridges, courts and highways.
That’s why we at David Lerner Associates have prepared this guide to acquaint you with many key aspects and benefits of owning municipal bonds — the smart investment for people who want attractive yields and tax-free income.
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Why buy tax-free municipal bonds from David Lerner Associates?
Every one of David Lerner Associates investment counselors is extensively trained in municipal bonds. We stand ready to help you choose the municipal bonds that are best suited for your investment portfolio.
The tax-free municipal bond investor is able to buy and sell directly from David Lerner Associates, one of the major municipal bond firms in the New York tri-state area.
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As one of the major municipal bond firms in the New York tri-state area, we maintain our own in- house trading department staffed by municipal bond specialists. Our in-house trading department maintains a large and varied inventory. As a result, the tax-free bond investor is able to buy and sell directly.
Our investment counselors will help guide you through the array of investment choices, designing a personal investment strategy that meets your individual needs and goals.
We hope this page will answer many of the questions you have on municipal bonds. Our investment counselors will be happy to meet with you and answer any additional questions you may have.
Why do bonds exist?
Public improvement projects such as streets, sewers, highways, bridges, mass transit, hospitals, schools and other public works require large sums of capital. To finance these projects, municipalities and municipal agencies borrow money by issuing bonds.
Why are municipal bonds exempt from taxes?
Since the enactment of the Federal Income Tax Amendment in 1913, the Internal Revenue Code has provided a specific exemption for municipal bonds. Municipal bonds are free from Federal, state and city income taxes for local residents. For example, if a New York City resident purchases any type of New York tax-free bond, that income is exempt from Federal, New York State and New York City income taxes. This is what we mean by triple tax free.
Why buy municipal bonds?
|Some of the major benefits of owning municipal bonds are:|
|History of Payment: Research shows that over 99% of all municipal bonds have paid interest and principal as promised.|
|Tax-Free Earnings: Interest earned from municipal bonds is exempt from Federal income tax and generally from taxes in the state or municipality in which they were issued for local residents.|
|Fixed Income: Since you choose the maturity dates of between one and 30 years, municipal bonds allow you to plan for both current and future income. If held to maturity, the investor locks-in the income for the lifetime of the bond. For example, if the investor purchases a $10,000 bond with a 5% coupon, he will receive $500 a year for the lifetime of the bond.|
|Liquidity: The large and active over-the-counter trading market for municipal bonds gives you the opportunity to sell your bonds at market value at any time.|
|Growth: Many bonds can be purchased at a discount which allows for capital appreciation if held to maturity.|
|Collateral: Historically, municipal bonds are excellent collateral, enabling investors to borrow against their investment.|
What types of municipal bonds are there?
|There are various types of municipal bonds, each issued for specific purposes.|
|General Obligation Bonds: Issued directly by state or local governments or their agencies to meet essential government functions such as schools and highway construction. These bonds are backed by the issuer’s pledge and its full faith, credit and taxing power to meet interest and principal payments.|
|Authority and Agency Bonds (Revenue Bonds): Created by states, counties, cities or a combination to perform specific functions such as the operation of bridges, tunnels, water or electric systems. These bonds pay interest and principal from the revenue generated by the facility.|
|Housing Bonds: These issues are secured by mortgage repayments on single family homes or multi-unit rental buildings.|
|Industrial Development Bonds: Made available by communities to encourage the construction of private purpose facilities such as factories and airports. These bonds are usually subject to the Alternative Minimum Tax.|
What are insured bonds?
Bonds for which a third party, an insurance company, guarantees the timely payment of principal and interest in the event that the issuer defaults. The strength of the bond insurer is an important factor to consider when purchasing insured bonds. The value of the bonds is not insured and is subject to market fluctuation.
What are zero coupon bonds?
These are bonds that are bought at a discount. Zero coupon bonds pay no annual interest. However, at maturity, they grow to full face value. There may be a substantial gain or loss if zero coupon bonds are sold prior to maturity.
What are the market risks?
While historically, public purpose tax-free municipal bonds have an exceptional record of paying interest and principal at maturity, investors must be aware that if they elect to sell the bond before maturity, depending on current interest rates and market conditions, the principal value of that bond could be more, less or the same as the original purchase price.
What yield would a taxable security have to pay to match a tax-free bond?
As the table below shows, individuals in the 35% Federal tax bracket would have to find a CD or other taxable investment yielding 6.92% to equal a tax-free bond yielding 4.5%. For residents with state and city income taxes, the taxable equivalencies can be even higher. For example:
Click here for a printable version of tax equivalency charts for NY, NJ, and CT
How are municipal bonds rated?
Two well-known rating services—Moody’s Investors Service and Standard & Poor’s Corporation—provide ratings as a guide to investors on the relative security and value of an issue. Since these rating services work on a fee basis, many bonds are non-rated. The investor should use extreme caution in the purchase of non-rated bonds. Here is how the two services rate bonds:
Ratings provided by Moody’s Investor Services and Standard & Poor’s. The Moody's ratings in the following ratings explanations are in parenthesis.
AAA (Aaa) - The highest rating assigned by Moody’s and S&P. Capacity to pay interest and repay principal is extremely strong.
AA (Aa) - Debt has a very strong capacity to pay interest and repay principal and differs from the highest rated issues only in a small degree.
A - Debt rated “A” has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse affects of changes in circumstances and economic conditions than debt in higher-rated categories.
BBB (Baa) - Debt is regarded as having an adequate capacity to pay interest and repay principal. These ratings by Moody’s and S&P are the “cut-off” for a bond to be considered investment grade. Whereas debt normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal in this category than in higher-rated categories.
BB (Bb), B, CCC (Ccc), CC (Cc), C - Debt rated in these categories is regarded as having predominantly speculative characteristics with respect to capacity to pay interest and repay principal. “BB” indicates the least degree of speculation and “C” the highest. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or market exposure to adverse conditions and are not considered to be investment grade.
D - Debt rated “D” is in payment default. This rating category is used when interest payments or principal payments are not made on the date due, even if the applicable grace period has not expired, unless S&P believes that such payments will be made during such grace period.
Ratings are subject to change.
** The ratings from “AA” to “B” may be modified by the addition of a plus or minus sign to show relative standing within major categories.
What are some of the risks of investing in municipal bonds?
Credit Risk: This is the risk that an issuer will default or be unable to make payments. The credit of the bond is backed by the municipality issuing the bond. The issuer of the bond must remain solvent in order to pay investors. Investors should consult with their investment counselor as to the credit risk or risk of default with a particular issuer.
Interest Rate Risk: Bond prices move inversely to interest rates. Long-term bonds are more exposed to interest rate risk than short-term bonds. Duration is the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates. The higher a bond’s duration, the higher its sensitivity to changes in interest rates. Investors who decide to sell prior to a call or maturity date may receive more or less than their original investment depending on market conditions and any mark-ups or mark-downs to the price of the bonds.
Call Risk: Many municipal bonds contain call features which allow for the bond to be recalled or retired before maturity at the discretion of the issuer.
Tax advantages depend on the individual’s income tax bracket. Since the enactment of the Federal Tax Amendment in 1913, the Internal Revenue Code has provided a specific exemption for municipal bonds. Generally, investors must purchase municipal bonds from their home state to be free of Federal, state and local income taxes. Investors need to consider the impact of inflation on their investments. Interest earned on certain municipal bonds is subject to the alternative minimum tax (AMT). Investors should consult with their tax preparer or tax advisor to determine if they are subject to AMT. Investors should consult their financial advisors as to the taxability of interest on municipal bonds.
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Copyright 2006. The Bond Market Association. Reprinted with permission.