MUNICIPAL BONDS
Municipal bonds are an excellent investment for
investors seeking to preserve capital and enjoy a
tax-free stream of income.
Municipal bonds are debt obligations issued by
states, cities, counties, and other governmental
entities to raise money to build schools, highways,
hospitals, and other projects for the public good.
Tax-exempt municipal bond issuers promise to pay investors a
specified amount of interest—usually paid twice a year and generally
exempt from federal, state, and local taxes. The principal amount
invested is returned on a specific maturity date. Municipal bonds
are among the most popular types of fixed income investments
available. Not only are they an essential component of any balanced,
well-diversified investment portfolio, they also offer a wide range
of benefits.
bond proceeds. Notes are also used to meet irregular cash flows
and unanticipated deficits, as well as raise immediate capital for
projects until long-term financing can be arranged. Bonds are
usually sold to finance longer-term capital projects.
Two basic types of municipal securities are general obligation
bonds and revenue bonds:
General Obligation Bonds
For general obligation, or GO bonds, principal and interest are
secured by the full faith and credit of the issuer and are supported
by the issuer’s taxing power. The issuance of general obligation
bonds is subject to voter approval.
• A
degree of safety with regard to payment of interest and
repayment of principal
Revenue Bonds
Revenue bonds have their principal and interest secured by revenues
derived from tolls, fees, charges or rents paid by users of the
facility built with the proceeds of the bond issue. Public projects
financed by revenue bonds include highways, bridges, airports, water
and sewage treatment facilities, hospitals, and low income housing.
• A
wide range of choices for bond rating, maturity, type of bond
and geographic location to fit individual investment objectives,
and risk tolerance
There are also certain bonds that come with special investment
features:
• Income that is generally free from federal and, in some cases,
state and local taxes1
• M
arketability should you decide to sell before maturity in order
to liquidate your position
TYPES OF MUNICIPAL BONDS
Municipal bonds include both long- and short-term issues. Shortterm securities (notes) typically mature in a year or less whereas
long-term securities (bonds) usually mature after a year or more
from issue. Notes are issued to raise money in advance of future
revenues such as tax income, state or federal aid payments, and
Insured municipals
Many municipal bonds are backed by municipal bond insurance
specifically designed to reduce investment risk. Insurance coverage
applies to the timely payment of principal and interest only; it
does not eliminate market risk.
Floating-rate and variable-rate bonds
These securities are attractive when interest rates are rising.
Generally, interest is periodically recalculated based on a percentage
of prevailing rates for Treasury bills or other interest rates.
Zero-coupon, compound-interest and multiplier bonds
These bonds are issued at a deep discount from their maturity
value and have no periodic interest payments. Investors receive
one payment at maturity equal to the principal invested, plus
interest compounded twice a year at the original interest rate.
Because they do not pay interest until maturity, their prices tend
to be volatile. These bonds may be attractive to investors seeking
capital for a long-term financial goal like retirement.
Put bonds
Some bonds have a “put” feature, which allows investors to redeem
the bond at par value on a specified date at some point before
its maturity date. If interest rates increase, you can generally redeem
the bonds at any put date, recover the principal and purchase
higher-yielding bonds.
HOW YIELDS AFFECT MUNICIPAL BONDS
There are basically two types of bond yields: current yield, and yield
to maturity. Current yield is the annual return on the dollar amount
paid for a bond. Yield to maturity (YTM) is the rate of return to
the investor earned from payment of principal and interest, with
interest compounded semiannually at the stated yield, until the
maturity date.
Tax-exempt yields are usually stated in terms of YTM, with yield
expressed at an annual rate. When the price of a tax-exempt bond
increases above its par value, it is said to be selling at a premium.
When the price of the bond is below par value, it is said to be
selling at a discount. Yield to maturity takes into account the
amount of the premium or discount, if any, and the time value of
the investment. For example, if you buy a bond with a 5% coupon
at par, its YTM is 5%.2
If you pay more than par, the YTM will be lower than the coupon
rate. If you pay less than par, the YTM will be higher than the
coupon rate.
Yield Comparison
5.00%
Tax-Exempt
Bond
7.00%
Taxable
Bond
$30,000
$30,000
$1,500
$2,100
$0
$735
Net Return
$1,500
$1,365
After-Tax Yield
5.00%
4.55%
Cash Investment
Interest
Federal Income Tax (35%)
The table below shows the yield you would need to earn from a
taxable investment to equal the yield on a tax-exempt security
(the taxable-equivalent yield). These calculations take into account
federal exemptions only.
Tax-Exempt /Taxable-Equivalent Yield
TAX BRACKET
Tax-Exempt
Yield %
10%
15%
25%
28%
33%
35%
2.0
2.22
2.35
2.67
2.78
2.99
3.08
2.5
2.78
2.94
3.33
3.47
3.73
3.85
3.0
3.33
3.53
4.00
4.17
4.48
4.62
3.5
3.89
4.12
4.67
4.86
5.22
5.38
4.0
4.44
4.71
5.33
5.56
5.97
6.15
4.5
5.00
5.29
6.00
6.25
6.72
6.92
TAX CONSIDERATIONS 3
It is important to note that municipal bonds are not free from
all tax implications. The following are tax-related matters you should
consider before investing in municipal bonds.
TAX BENEFITS OF MUNICIPAL BONDS
Under current federal income-tax law, the interest income from
investing in municipal bonds is free from federal income taxes
unless you are subject to the alternative minimum tax (AMT). In
that case, a portion of your income may be subject to taxation.
In most states, interest income received from securities issued by
governmental units within the state is also exempt from state and
local taxes.
Gains or Losses
Capital gain or losses may be generated on a tax-exempt security
if you sell it at a profit in the secondary market before maturity,
or alternatively, if you sell it for less than you originally paid for it.
Sometimes, the gain or loss may be affected by required cost-basis
adjustments. Under current law, up to $3,000 of net capital losses
can be used annually to reduce “ordinary income” on your tax return.
Capital losses can be used without limit to reduce capital gains.
The adjacent table (“Yield Comparison”) illustrates the effect of
federal income taxes on yields of tax-exempt bonds versus taxable
bonds. As the calculations reveal, the tax-exempt municipal bond
would provide the better yield after taxes are taken into account.
Moreover, the tax-exempt security would be an even better
investment if you accounted for state and local income taxes
when calculating returns on the taxable investment.
Tax Treatment on Discount Bonds
Special rules apply to tax-exempt bonds bought at a discount. A
market discount generally exists when a bond is bought at a price
below par. The discount is the difference between the purchase
price of a bond and its maturity value or redemption price. Under
tax law, discounts will be taxed at the time a bond is sold or
redeemed; however, they could now be taxed as ordinary income,
as opposed to a capital gain.
A special provision for original issue discount (OID) bonds exempts
their discount from tax. The special de minimis rule provides that if
a bond is purchased with only a small discount—less than 0.25% of
the face value of a bond for each complete year between the bond’s
purchase date and maturity date—the discount is considered to be
zero. A discount on a municipal bond will therefore be taxed as
ordinary income if the discount is more than this amount and as
capital gains if it is less than this amount. For those in the top tax
bracket this could mean the difference between paying 15% and 35%.
Alternative Minimum Tax (AMT)
The AMT is designed to prevent taxpayers from escaping their
fair share of tax liability through certain tax breaks. Under the Tax
Reform Act of 1986, interest on most tax-exempt private-activity
bonds will be a “tax preference item” for individuals subject to AMT.
A preference item is an income source that is not included in the
normal tax calculation.
One of the benefits to investors in private-activity bonds—or AMT
bonds—is that the range of yields will tend to be higher than for
non-AMT bonds. This extra yield is an advantage for individuals who
are not subject to AMT.
Medicare and Social Security Benefits
If you receive Medicare or Social Security benefits, the 100%
tax-free status of your municipal bond interest may be impacted.
It is important to note that the modified adjusted gross income
(MAGI) calculation for Medicare income-relating purposes includes
all tax-exempt income, such as that from municipal bonds. When
making investment decisions, the standard taxable equivalent
yield calculations may need to be adjusted.
RISK CONSIDERATIONS
Although buying municipal bonds is generally considered a conservative investment strategy, there are risks you should consider.
Credit Risk
This is the risk associated with the issuers ability to meet its
financial obligations. Rating companies such as Moody’s Investment
Service, Standard & Poor’s, and Fitch Ratings reflect a professional
and independent assessment of the issuer’s ability to make interest
payments and repay the bond’s face value at maturity. These bond
ratings are important benchmarks and a minimum rating of
“investment grade” means it is suitable for preservation of
investment capital.
Historically, issuers have had an excellent record of making principal
and interest payments in a timely manner, but in general, as with
any investment, the higher the return you seek, the higher the
risk. Keep in mind that credit ratings should not be the sole basis
for any investment decision.
A summary of the major rating agencies’ credit classifications is
shown in the adjacent table.
Summary of Credit Ratings
Moody’s
Standard &
Poors
Fitch
Prime
Aaa
AAA
AAA
Excellent
Aa
AA
AA
Upper Medium
A
A
A
Lower Medium*
Baa
BBB
BBB
Speculative
Ba
BB
BB
Very Speculative
B, Caa
B, CCC, CC
B, CCC, CC, C
Default
Ca, C
D
DDD, DD, D
*Denotes the lowest class of “investment grade” bonds
Interest Rate Risk
This involves fluctuations in the interest rate and the resulting
effect on the value of your bond. The interest rate of most
municipal bonds (also known as the coupon rate) is paid at a
fixed rate throughout the life of the bond. If interest rates in
the marketplace rise, the municipal bond you own will be paying a
lower rate (or yield) relative to the yield offered by new issues.
In addition, municipal bond prices fluctuate in response to changing
interest rates—prices increase when interest rates decline, and
prices decrease when interest rates rise. If interest rates rise, new
issues come to market with higher yields than older securities, thus
making the older securities worth less and causing a bond’s price
to decrease. Of course, the converse is true if interest rates fall.
Although market risk and interest risk can’t be diversified away, it
can be somewhat hedged by a laddered portfolio that limits the
majority of the exposure. As bonds mature in a higher interest
rate environment, the proceeds are invested with higher coupon
paying bonds.
Call Risk
Call risk is the risk faced by the holder of a callable bond where
the bond issuer will take advantage of the callable bond feature and
redeem the issue prior to the maturity date. Capital is returned with
a premium added in exchange for the early debt repayment. Your
income stream ends earlier than expected, and in most cases, you
will be reinvesting in a less favorable lower interest rate environment.
UNDERSTANDING YOUR CHOICES
Talk to a Wintrust Wealth Management Financial Advisor to
learn more about municipal bonds and determine if they are an
appropriate investment for you.
wintrustwealth.com
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1. Income is generally free from federal and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, are subject to taxes. Income may be subject to federal Alternative Minimum Tax (AMT).
2. This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, nor is it indicative of future results.
3. Our firm does not provide tax or legal advice but can offer referrals to agencies that do. This and any accompanying information was prepared by or obtained from sources we believe to be reliable, but our firm does not guarantee its
accuracy or completeness. The material is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
Securities and insurance products offered through Wayne Hummer Investments, LLC (Member FINRA /SIPC), founded in 1931. Trust and asset management services offered by The Chicago Trust Company, N.A. and Great Lakes Advisors, LLC,
respectively. Investment products such as stocks, bonds, and mutual funds are not insured by the FDIC or any federal government agency, not bank guaranteed or a bank deposit, and may lose value. ©2014 Wintrust Wealth Management.
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