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




b.
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
Related Articles
  1. Investing Basics

    Calculating the Margin of Safety

    Buying below the margin of safety minimizes the risk to the investor.
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: Guggenheim Enhanced Short Dur

    Find out about the Guggenheim Enhanced Short Duration ETF, and learn detailed information about this fund that focuses on fixed-income securities.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI KLD 400 Social

    Find out about the iShares MSCI KLD 400 Social exchange-traded fund, and learn detailed information about its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: Guggenheim BulletShrs 2018 HY CorpBd

    Find out about the Guggenheim BulletShares 2018 High Yield Corporate Bond ETF, and get information about this ETF that focuses on high-yield corporate bonds.
  7. Mutual Funds & ETFs

    ETF Analysis: PowerShares DWA SmallCap Momentum

    Find out about the PowerShares DWA SmallCap Momentum Portfolio ETF, and explore detailed analysis the fund's characteristics, suitability and recommendations.
  8. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Total World Stock

    Learn about the Vanguard Total World Stock exchange-traded fund, which invests in stocks located in numerous countries with a high level of diversification.
RELATED TERMS
  1. Net Line

    The amount of risk that an insurance company retains after subtracting ...
  2. Political Risk Insurance

    Coverage that provides financial protection to investors, financial ...
  3. Maximum Drawdown (MDD)

    The maximum loss from a peak to a trough of a portfolio, before ...
  4. Gross Exposure

    The absolute level of a fund's investments.
  5. Priori Loss Estimates

    A technique used by insurance companies to calculate loss reserves.
  6. Value Of Risk (VOR)

    The financial benefit that a risk-taking activity will bring ...
RELATED FAQS
  1. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
  2. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  3. What are common delta hedging strategies?

    The term delta refers to the change in price of an underlying stock or exchange-traded fund (ETF) as compared to the corresponding ... Read Full Answer >>
  4. How does being overweight in a particular sector increase risk to a portfolio?

    An investor who is overweight in a particular sector risks a loss in value for the portfolio if there is a downturn in that ... Read Full Answer >>
  5. What are the primary risks an investor should consider when investing in the retail ...

    The retail sector consists of companies operating in multiple industries such as specialty retail, general retail, food and ... Read Full Answer >>
  6. What risks do I face when investing in the insurance sector?

    Like all equity investments, insurance companies present investors with market risk. Insurance companies, like banks, also ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!