Municipal bonds (often referred to as muni bonds) are issued by state, city, and county agencies and provide interest that is tax-free at the federal level. The interest may also be tax-free at the state level if the owner of the bonds is a resident of the state that issued the bonds.
Due to this tax-free interest, it's important to understand yield equivalence so you can easily compare tax-free versus taxable interest rates. To convert a muni bond yield to its taxable equivalent, simply divide the interest rate by the inverse of the potential investor's marginal tax bracket.
Taxable Equivalent Yield = Coupon Rate
(1-marginal tax rate)
For example, if a muni bond is paying 4% interest and the investor is in the 25% tax bracket, divide 4% by .75 for a taxable equivalent yield of 5.33%.
Taxable equivalent yield = .04/(1-.25) = .04/.75 = .0533 or 5.33%
You can then compare the muni to taxable (government or corporate) bonds of similar maturity and risk. If other bonds pay less than 5.33%, the muni offers an advantage.
Municipal bonds are issued as one of two types:
- General Obligation Bonds - GO
- These bonds are backed by the full faith and credit of the issuer.
- GOs carry less risk, since the issuer can collect (and thus, if necessary, raise) taxes to service the debt.
- Revenue Bonds
- These are used to finance specific projects, such as an airport or sports facility.
- Revenue bonds are backed only by the fees generated by the facility - if they are insufficient, the bonds could go into default.
Since 1986, some bonds issued by a municipality are no longer tax-exempt. Only those classified as public-purpose bonds offer tax-exempt interest. Others, known as private-purpose bonds, are fully taxable, unless their use is specifically exempted. Private-purpose bonds include those issued to finance convention centers, sports facilities and industrial development. Permitted private-purpose bonds that are exempt from regular federal income tax are still subject to the Alternative Minimum Tax (AMT).
Exam Tips and Tricks
Consider this sample exam question:
- Which of the following types of municipal bonds would probably not offer tax-exempt interest?
- To fund a new bridge
- To fund a new school
- To fund a new convention center
- To fund a new sewer system
The correct answer is "c", since this is an example of a private-purpose bond
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