DEFINITION of 'Taxable Municipal Bond'

A taxable municipal bond is a fixed-income security issued by a local government such as a city or county or related agencies which has its income not exempt from tax. Taxable municipal bonds are generally issued to finance a project or activity that does not provide a major benefit to the public. In such cases, the federal government will not permit a tax-exemption.

BREAKING DOWN 'Taxable Municipal Bond'

A prominent feature of most municipal bonds is that they are tax-exempt. A municipal bond is a bond issued by local and state governments to fund projects for the betterment of the community, such as building schools, highways, hospitals, etc. A municipality may also issue a bond on behalf of a private company which may be otherwise unable to obtain financing for the project. In this case, the private activity bonds attract private businesses and the jobs they would bring to the area. An investor who buys a muni bond is lending money to a municipality who promises to pay interest periodically until the bond matures, at which point the principal investment is repaid to the investor. To encourage investors to purchase these bonds, the bonds are set up as exempt from federal taxes and some state taxes. However, the tax-exempt status of municipal bonds is only granted if the projects funded from the proceeds of the issue provide a significant benefit to the community at large.

Interest from municipal bonds issued to finance projects with no obvious public benefits is taxable since the federal government will not subsidize the financing of these projects. Since income from such bonds is taxable in the hands of the investor, taxable municipal bonds offer risk-adjusted yields that are comparable to those available from other taxable entities such as corporate bonds and other government agency bonds. Some taxable municipal bond issues are exempt from state and, often, local taxes, in which case, investors who reside in the state of issuance are not taxed on their interest earnings at the state level. Thus, the effective yield they earn on the bond will actually be higher than the stated yield.

The majority of taxable municipal bonds are issued to finance the shortfalls of state and local pension funds. Other situations where taxable municipal bonds may be issued include to finance local sports facilities, investor-led housing, or to refinance debt. Build America Bonds (BABs) are an example of taxable municipal bonds; they were created under the American Recovery and Reinvestment Act (ARRA) of 2009 and, although taxable, have special tax credits and federal subsidies for either the bond issuer or holder.

Taxable municipal bonds are popular among institutional investors and mutual funds that cannot take advantage of tax breaks.

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