Tax-Free Possibilities for Upper-Income Earners; Yield to Call or Maturity?

The first half of 2008 was notable for stock market volatility, low interest rates, and the increasing likelihood of higher taxes by the decade’s end. This cocktail of malaise bodes well for what is often a ho-hum corner of the debt market: municipal bonds.

The normally placid muni bond market has been roiled by a confluence of variables related to the stock market, slow economic growth, and credit-market woes. One result has been yields high enough to get the attention of investors who normally stick to Treasurys.

Don’t let the muni market’s quiet reputation fool you. Finding opportunities in the municipal bond market means navigating a complex landscape.

Tax Rates
Municipal bonds are issued by government agencies to pay for public works projects such as roads, sewers, and stadiums. In general, the federal government cannot tax investment income paid by state and municipal governments, and vice versa. So just as income from Treasurys is typically exempt from state and local taxation, so too is municipal bond income exempt from federal taxation, with some exceptions. If a bond was issued by a municipality outside the state in which you reside, the interest could be subject to state and local income taxes. If you sell a municipal bond at a profit, you could incur capital gains taxes. Some municipal bond interest could be subject to the federal alternative minimum tax.

These tax benefits allow the issuing agencies to pay lower interest rates than comparable taxable bonds, so investors in the lower tax brackets have little incentive to accept the normally lower muni yields. However, the higher an investor’s tax rate, the greater the potential return from a municipal bond. (See worksheet.)

Risk Rates
Municipal bond default rates are low. Even munis carrying S&P’s triple-B rating (three steps below the highest rating) have had a 0.32% historical default rate.¹ However, the risk level can vary depending on the type of bond. A general obligation bond is backed by the full faith and credit of the issuing agency, which may levy taxes to meet interest obligations. A revenue bond is typically paid by the proceeds from a project, such as greens fees collected on a municipal golf course. If revenues dry up, it can endanger interest payments. In general, municipal bonds issued by cities and towns tend to carry slightly more risk than those issued by states.

Call Risk
Some municipal bonds can be repaid early at the issuer’s option. These callable bonds pay one rate if the issuer lets them mature, but a lower rate if it pays them off early. If a bond is callable, investors can expect to earn the yield to call rather than the yield to maturity. Yields and market value will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost.

If you don’t already own municipal bonds, now may be a good time to consider whether they may be appropriate for your situation. If you already own some munis, it may be a good time to review your position in light of this year’s unusual activity.

1) The Wall Street Journal, March 3, 2008

This material was written and prepared by Emerald Publications.
© 2008 Emerald Publications