Municipal Bonds: A Little Home Cooking
By Craig Hackler, Financial Advisor, Raymond James Financial Services
Once the almost
exclusive
domain of
institutional investors the
municipal bond market has
become a magnet for individual
investors. Since these
bonds are issued by state and
local governments, the principles
of federalism (remember
high school civics?)
demand that the interest
from municipal bonds be
exempt from federal taxation.
Although they are generally
free from federal taxes, these
bonds may be subject to state
and local taxation. The interest
on private activity bonds
may not be tax-free under the
alternative minimum tax system.
The popularity of
municipal bonds has soared
among individuals as they
seek federal tax-free interest
to combat the inherent penalties
of high income: deduction and
exemption limitations and higher marginal
tax rates.
A municipal bond is essentially a
promissory note. When an investor buys
a municipal bond, he/she is lending
money to the issuing state or local government.
In return for the loan, the issuer
pays interest at a specified rate and, at the
end of the period, pays back the principal.
Funds raised through the sale of municipal
bonds are generally used to finance projects
that benefit the public. The two most
common types of municipal bonds are
general obligation bonds and revenue
bonds. General obligation bonds are
backed by the “full faith and credit” and
the taxing power of the issuer. Revenue
bonds are secured by the income from the
specific project they were issued to
finance.
Comparing the yield on a municipal
bond to the return on a similarly rated,
fully taxable investment is basically a function
of the investor’s tax bracket. Generally,
the higher the tax bracket, the more the
potential benefit from investing in municipal
bonds. To illustrate this point, if an
individual is in the 25% federal tax bracket,
a municipal bond paying interest at 6%
will generate the same amount of income
—after tax—as a fully taxable investment
earning interest at 8%. For an individual
in the 35% bracket, that same municipal
bond paying interest at 6% will be equivalent
to an almost 9.2% taxable return.
This taxable equivalent yield will be even
greater for investors who purchase home
state bonds as these are also exempt from
their respective state income taxes.
Remember, investing involves risk and you
may incur a profit or a loss. The example
provided is hypothetical and
does not suggest or guarantee
particular rates of return for
any investment.
Another important factor
in evaluating municipal
bonds is how long the investment
will last. Different
bonds have different maturity
dates and choosing the maturity
date that is right for an
investor depends upon
his/her own investment
objectives. Retired individuals
who are collecting social
security should be aware that
municipal bond income is
included in the determination
of taxable social security benefits
even though it is not
part of their federal taxable
income.
Municipal bonds offer
an attractive investment alternative
for many individuals.
They can be purchased
directly or through tax-free bond funds or
unit investment trusts (UIT). Remember
to compare returns on municipals with
other investments using a taxable equivalent
yield based upon the investor’s marginal
tax rate. Of course, this brief article
is no substitute for a careful consideration
of each investor’s particular financial situation.
Before implementing any significant
tax or financial strategy, contact an
investment advisor.
Craig Hackler holds the Series 7 and Series
63 Securities licenses, as well as the Group I
Insurance license (life, health, annuities).
Through Raymond James Financial Services,
he offers complete financial planning and
investment products tailored to the individual
needs of his clients. He will gladly
answer your questions. Call him at
512.894.0574 or 800.650.9517
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