What are Tax Free Municipal Bonds and how do they work?

Tax Exempt and Tax Free Yield

Interest on Municipal debt is normally exempt from federal tax. Because of this, they normally issue bonds with below market coupon rates. To fully judge the yield value of a municipal investment, you should examine the tax free yield that it offers. A 5.5% Municipal Bond offered at par for an investor in the 28% bracket will offer that investor a better overall yield than the 5.5% coupon rate. The formula breaks down as follows:

5.5 coupon rate divided by 100 minus the tax bracket will give the investor their current tax free municipal bond yield.

5.5 divided by 72 (100-28) = 7.64%. This is what the municipal bond is equal to in a taxable investment to this investor. If the person was looking for a corporate bond or other taxable investment, he would need to yield equal or better than 7.6% in that other investment to beat the municipal bond yield.

Municipal securities are more attractive to investors in higher tax brackets. If we place another investor into the above equation with a lower tax bracket, the yield will not be as strong.

Using a 20% tax rate:

5.5% divided by 80 (100-20) = 6.89%

Investors who purchase Municipals issued within their own state are usually exempt from state and local tax as well. This is known as being triple tax free. Munis purchased from U.S Territories (Puerto Rico, Virgin Islands, etc.) also qualify for triple tax free status.

Municipals are not exempt from capital gains tax. If a person sells a muni bond at a profit above their cost, the profit is fully taxable as a capital gain. This applies to Corporate bond issues as well.

Municipal Bond Rates:

Rates or coupons tend to trade lower than treasuries, given the tax free status of them. As you can see from the above examples, the tax exempt yields trade significantly higher.

Types

General Obligation (GO Bonds) bonds or notes are backed by the taxing power of the municipality. A school project is a good example of a bond issue being backed by taxes. The homes and property areas will be assessed a property tax increase to help bay for the bond issue.

See more on General Obligation Bonds

Revenue Bonds are backed by an issuers ability to generate revenue to fund the issue. Bridges and tolls are the best examples of this type of underwriting. Revenue bonds are "generally" not rated as high as G.O. Bonds, simply because taxes are a more definitive source for an issuer. Revenue bonds rely on constant revenue to collect money required to meet debt service (bond interest and principle payments.

Recommended Book Titles on Municipal Bonds

The Fundamentals of Municipal Bonds, 5th Edition - This informative volume is an update of the long-heralded classic text on the municipal securities market. Written by Judy Wesalo Temel for The Bond Market Association–the leading trade association that represents the players in this market and whose members underwrite 900f all municipal bonds–this newly revised Fifth Edition deals comprehensively with the many recent developments in the municipal securities market. It provides a basic understanding of the market for a wide range of readers, including experienced professionals, public officials, private investors, academicians, and students.

Handbook for Muni Bond Issuers (Bloomberg Professional Library) - Joe Mysak, editor of Grant's Municipal Bond Issuer and Grant's Municipal Bond Observer, is a key resource to anyone in the muni market. Mysak, a longtime observer and insider in muni-bonds, has written an accessible and informed book on the issuance process. Mysak covers everything an issuer, veteran or novice, needs to know--from the basics through what to do after the sale.

The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More - The Bond Book cuts through the salesperson’s double-talk to give you a broad, useful overview of bonds. Straightforward and clear, it provides specific information and hands-on guidance to make bonds an important part of your investment portfolio—both today and in the future.

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