Characteristics, Uses and Taxation of Investments - Zero-Coupon and Municipal Bonds

Zero-Coupon Bonds: corporations are the typical issuers (please refer to the discussion of treasury STRIPS for a description of the private sector-created U.S. government zero coupon bonds). Such bonds are issued at a discount to face value. The return is the accrual to par over time. Because there are no semi-annual coupon payments, the duration of a zero-coupon bond is equal to its maturity. For the same reason, these bonds are not subject to reinvestment risk. Income tax is payable on the annual accretion or phantom income, even though the bond holder receives no money until maturity.

c. Municipal Bonds: these are interest-bearing certificates issued by municipalities (states, cities, counties, school districts, parishes, etc.). They are held in taxable portfolios of wealthy individuals in higher tax brackets to take advantage of the tax-exempt yield. Residents of a state with a state income tax that hold municipal bonds for that state often enjoy exemption from state income tax. Finally, interest income on obligations of a United States territory or possession or any political subdivision thereof (e.g. a bond issued by St. Thomas or its capital Charlotte Amalie) is exempt from federal, state and local income tax (triple tax-exempt). Gains on the sale of a bond, by contrast, are subject to federal income tax. [The municipal market is inefficient due to its historically and, of late, increasingly retail orientation. Changes in the federal tax code making such bonds less attractive to banks and insurers and increasingly attractive to individual investors have been responsible for this shift in orientation. Additionally, because of their tax-exempt income, municipal bonds trade infrequently adding to the market's fragmentation and pricing inefficiency (Why would investors convert tax-exempt income (buy-and-hold) into a current taxable gain by selling a municipal bond?). Dealers can profit from such inefficiencies, yet some are chary of holding significant inventory given the difficulty in hedging municipal bond positions. Finally, there is no central pricing facility as municipal bonds trade over-the-counter (OTC), rather than on an exchange.]. Additionally, there are rules for the determination of basis when accreting a discount on an original issue discounted bond (OID) versus one purchased at a discount in the secondary market and for the straight line depreciation of bonds purchased at a premium. Once properly determined, such basis is used as the point of departure in figuring gains and losses when bonds are sold and their tax status. A critical question to ask when purchasing such bonds is how they are to be repaid. An assessment of their credit quality and, by extension, default risk is crucial. Bonds may be issued in either term or serial form. With the former, principal is repaid in full at maturity whereas in the latter category the municipality is required to retire a certain amount of principal each year. Some municipal bonds may carry insurance against default which serves to reduce their credit risk. American Municipal Bond Assurance Corporation (AMBAC), MBIA Insurance Corporation and Financial Guaranty Insurance Company (FGIC) are major insurers of municipal bonds. Because interest in municipal bonds is not subject to federal income tax, investors need to know how to calculate the taxable equivalent yield to compare yields of municipal bonds with taxable bonds. This is a concept that is central to the understanding of the role of municipal bonds in a taxable portfolio and is often tested as a result.

Example: Pretax yield = tax - exempt yield/1-marginal tax rate. For an investor in the 30% marginal tax bracket, a municipal bond paying 5% would have a taxable equivalent yield of 7.14% calculated as follows. 7.14%=5%/1-30%. One may infer from the following table that the higher the individual's marginal tax bracket, the greater the advantage of using a municipal bond.
Municipal Bond Yield
4% 5% 6% 7% 8% 9%
Tax Rate
15% 4.71% 5.88% 7.06% 8.24% 9.41% 10.59%
27% 5.48% 6.85% 8.22% 9.59% 10.96% 12.33%
30% 5.71% 7.14% 8.57% 10.00% 11.43% 12.86%
35% 6.15% 7.69% 9.23% 10.77% 12.31% 13.85%
38.6% 6.51% 8.14% 9.77% 11.44% 13.03% 14.66%

Types of Municipal Bonds
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