Taxation of Municipal Bond Interest
The interest on tax-exempt municipal bonds is exempt from federal income taxation, an important consideration to bond buyers, especially those in the higher income tax brackets. State tax treatment is an important consideration to bond buyers as well, since the interest on tax-exempt municipal securities is exempt from state income taxes in the state where they are issued. Most municipal bonds are tax-exempt, but some are not (i.e., they are fully taxable). The offering document for a bond issue (its “Official Statement”) will state if the bonds are tax-exempt or taxable. In general, if the bonds are issued by a municipality for a public purpose (e.g., to construct a public school building) they will be tax-exempt. If the bonds are issued by a municipality for “private activity” purposes, they will be taxable bonds and the income from these municipal bonds will be fully taxable for both state and federal income tax purposes.
Current rules on the exemption of municipal bond interest varies state-to-state. In most states, bonds issued by the state or one of its political subdivisions are exempt from personal income taxation, but not the interest on bonds issued by another state or one of its political subdivisions.
Serial bonds allow issuers (i.e., municipalities) to structure their debt by issuing bonds in varying principal amounts with consecutive maturity dates. For example, an issuer might sell $1,000,000 in bonds with annual maturities of $100,000 per year for 10 consecutive years. As serial bonds mature the issuer is able to repay the total principal over time (rather than all at once), and as such will be better able to match revenue projections with debt service payments.
Single maturity or “term bonds” are debt instruments where the entire principal amount of the bond is paid on the maturity date. For example, an issuer might sell $1,000,000 in bonds, all stated to mature in 20 years. Prior to the maturity date, however, there may be mandatory sinking fund redemptions of this bond. A schedule of the mandatory sinking fund redemptions will be shown in the official statement for the bond issue. Thus, portions of this 20-year bond will be retired before the 20th year in amounts and on the dates set forth in the official statement.
Par Bonds, Discount Bonds and Premium Bonds
A par bond is a bond sold at its face (or “par”) amount (e.g., a $5,000 par bond would be sold for $5,000). A discount bond is a bond with a below-market coupon rate that is sold at a price less than par, and a premium bond is a bond with an above-market coupon rate that is sold above par. The decision to issue discount or premium bonds (or some combination of both) is made by the underwriter of the bond issue for marketing purposes. After the initial offering, changes in market rates will affect the prices of bonds, thereby making them par, discount or premium bonds depending on their coupon rate and the market rate for the bond at the time of sale. Contact your accountant or financial advisor with respect to the taxation of the discount or premium on your bonds.
Municipal bonds providing for the optional redemption or “call” by the issuer prior to its stated maturity date are known as callable bonds, and are generally callable at any time upon 30-days notice after a certain numbers of years have elapsed from the date they were issued (typically, 10 years). The decision to call the bonds is solely at the option of the municipal issuer. If the issuer decides to call its bonds, the owner will be paid back at that time, and no future interest payments will be received. Premiums can be applied to the early redemption of callable bonds, although most municipal bonds are currently callable at par. Thus, all or a portion of an issuer’s callable bond issue may be redeemed prior to the stated maturity of the bond issue. The official statement for a callable bond will describe the method of redemption.
Yield to Maturity and Yield to Call
The yield to maturity is the return to the purchaser of a fixed coupon rate bond at a certain price. For example, a 20-year 5.00% non-callable bond purchased at 105% of par will have a yield to maturity of 4.615% (the yield to maturity is less than the coupon rate since the purchaser is paying more than par for this bond). If the same bond was purchased at 95% of par (i.e., at a discount), its yield to maturity would be 5.412% (the yield to maturity is greater than the coupon rate since the purchaser is paying less than par for this bond). The yield to call is the return to the purchaser of a callable bond assuming it is called on its call date. For example, if the 20-year 5.00% premium bond purchased at 105% is callable in 10 years, the yield to call would be approximately 4.377% (i.e., less than its yield to maturity). When investing in bonds it is important to know the yield to maturity (YTM) or yield to call (YTC) in order to know the actual return of the investment – don’t just look at the coupon rate. Discuss this with your securities broker or financial advisor.
Some municipal bonds are issued with “credit enhancement” which means that a third party promises to pay the principal and interest on the bond if the issuer fails to do so. Examples of such third parties are (1) a bank letters of credit, (2) a bond insurance company, (3) credit programs of federal or state governments or federal agencies, or (4) state school credit guarantees. With credit enhancement, an issuer can expect to sell its bonds at a lower yield to the investor due to the higher creditworthiness of its debt. Discuss any credit enhancements with your securities broker or financial advisor.
Zero Coupon Bonds
Zero coupon bonds are bonds that are sold at a discount with no periodic interest payments. All interest is effectively paid at maturity when the purchaser receives the full principal amount of the bond.
Capital Appreciation Bonds
Capital appreciation bonds (CABs) are bonds that are sold at a discount that provide for the reinvestment of the initial investment at a compounded rate until the maturity, at which time the investor receives the total par amount (or “future value”) of the CAB. CABs are zero coupon bonds.
Variable Rate Bonds
Variable rate demand obligations (VRDOs) are bonds where the interest rate varies, or changes periodically (e.g., weekly or monthly). VRDOs are typically sold with high minimum denominations (e.g., $100,000). The VRDO structure allows the securities to be sold at par. They are also known as “floating rate” bonds.
Stanley Stone is the president of stanleypstone.com. He is a Certified Independent Public Finance Advisor (CIPFA) and an associate member of the National Association of Bond Lawyers. Stanley loves the theater and attends many plays, operas and ballets each year in New York City.