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

    How Are Zero-Coupon Municipal Bonds Taxed?

    What every investor needs to know about taxes and zero-coupon muni bonds.
  2. Investing

    A Look at the Pros and Cons of Muni Bonds

    Considering muni bonds? Here's a look at their pros and cons.
  3. Investing

    Think Twice Before Buying Tax-Free Municipal Bonds

    Municipal bonds are relatively safe, tax-exempt securities--but they are not without drawbacks. Due diligence is required.
  4. Investing

    Consider These Municipal Bond ETFs

    Though relatively low-risk, there are still some factors to consider when taking the plunge into municipal bond ETFs.
  5. Financial Advisor

    How to Find the Best Bets in Muni Bonds

    Approach investing in municipal bonds the same as you would investing in stocks.
  6. Investing

    The Basics Of Municipal Bonds

    Investing in these bonds may offer a tax-free income stream but they are not without risks.
  7. Investing

    4 Tax-Free Muni Bond ETFs to Consider

    Tax free municipal bond ETFs are an excellent way to build wealth slowly. Here are 4 you should consider.
  8. Investing

    The Top 5 Municipal Bond Funds for 2016

    Understand how the addition of municipal bond mutual funds can enhance a portfolio, and learn the top-rated municipal bond funds to consider for 2016.
  9. Investing

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
  10. Investing

    Muni Bond ETFs to Date 2016 Performance Review (MUB, XMPT)

    Learn how municipal bond exchange-traded funds have performed year-to-date in 2016, and which ones have performed the best and the worst so far.
Frequently Asked Questions
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The concept of CAGR is relatively straightforward and requires only three primary inputs: an investments beginning value, ...
  2. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors with insight into how efficiently a company (or more specifically, ...
  3. What is the difference between Communism and Socialism?

    Learn how some countries are incorporating socialist methods into capitalism.
  4. What's the difference between a stop and a limit order?

    A limit order is an order that sets the maximum or minimum at which you are willing to buy or sell a particular stock. With ...
Trading Center