Why do municipalities issue taxable bonds

Although it is relatively uncommon, some muni bonds are federally taxed if the holder is subject to alternative minimum tax AMT. If you are unsure whether a specific muni is subject to AMT, consult the broker before purchase. For example, a bond that is used for a particular municipal improvement that is not backed by the credit of a state or municipality, but rather that of a corporation such as an airline backing an airport improvement bond , would be subject to AMT.

In fact, most aren't. This provides a big advantage over taxable bonds, even with lower interest. To determine whether or not a tax-free bond is a better option than a taxable bond, simply apply the Tax Equivalent Yield TEY formula. Another important note here is that you will likely be subject to a capital gain or loss if you sell the bond before it matures. If you sell higher than the adjusted issue price, then you book a capital gain. If you sell for less than the adjusted issue price, you suffer a capital loss, which can be utilized to reduce your overall tax bill.

This is also known as the original issue discount or OID. This, in turn, allows you to buy more bonds if you so desire. The longer the bond has to mature, the bigger the discount you will receive. Of course, you have to hold up your end of the bargain to see the greatest benefits.

And that simply means that you must remain patient until the bond matures. Most zero-coupon municipal bonds mature between eight and 20 years. The municipal market size in the United States. Municipal bonds are one of the safest investments you will find with an average default rate of 0. Municipal bonds are free from federal taxes and are often free from state taxes. If the bond purchased is from a state other than the purchaser's state of residence, the home state may levy a tax on the bond's interest income.

Alternatively, if the bondholder sells the bond and there is a gain, they are subject to capital gains tax. Also, when bonds are purchased at a discount on the secondary market, capital gains tax may apply when the bond is redeemed. Because municipal bonds are generally free from taxes, they become an attractive investment when taxes increase.

Municipal bonds issued by the state are free from federal taxes and are often free from taxes from the state that issued the bond. Munis are often free from state taxes if the bond issuer is not in the purchaser's state of residence. In states with no income tax, the purchaser can purchase munis from any state without a state tax obligation. Form INT reports interest from municipal bonds. Although reported, federal taxes are not due.

Municipal bonds ETFs are generally free from federal and state taxes if they hold only tax-exempt bonds. However, if the municipal bond ETF has a combination of tax-free and taxable interest, taxes may be due on the federal and state level. Municipal bonds can be purchased from a broker-dealer or bank that deals with municipal securities, from an investment advisor, through a self-managed account, or in a muni mutual fund or exchange-traded fund ETF.

While traditional and zero-coupon municipal bonds are an attractive investment for many due to the tax savings, you must understand the potential tax liabilities before making a purchase.

In the absence of proper due diligence, you may be surprised by an unexpected tax bill. This gives a state the flexibility to even fund high-value projects, including qualified and unqualified ones. Refinancing outstanding muni bonds: The usual practice of the issuing authority is to advance refund deals with higher borrowing costs using tax-exempt bonds with low borrowing costs.

This phenomenon changed after the introduction of the Tax Cuts and Jobs Act of , which discourages advance refunding through tax-exempt bonds. In addition, in the low interest rate scenario, the borrowing costs of taxable bonds are only marginally higher, further boosting issuance of taxable muni bonds. Investors lost confidence during the financial crisis of and even invested in highly rated government bonds.

To restore confidence, the federal government introduced financial measures such as the Build America Bonds programme. In June , USD Taxable muni bonds offer more attractive yields than other fixed-income investments. Taxable muni bonds look attractive because they offer higher yields without having to take on too much additional credit risk. They also provide an alternative way for investors to widen their portfolios without compromising credit quality.

Yields on taxable muni bonds are more attractive than yields on many other-fixed income investments. Taxable muni bonds provide better yields than corporate bonds for taxpayers in all tax brackets. Following the passage of the Tax Cuts and Jobs Act in December , municipal issuers are no longer allowed to advance refund prior debt on a tax-exempt basis. Assuming favorable market conditions, issuers may consider the issuance of taxable bonds to refinance prior debt when the refunding escrow exceeds 90 days to the call date.

Consideration should be given as to the potential foregone savings from a taxable refunding versus waiting to current refund the bonds on a tax-exempt basis under similar market conditions.

Call Provisions Issuers should recognize that some features that enhance flexibility, such as an early call provision, may be more costly to exercise for taxable debt than for tax-exempt debt. The increase in municipal taxable issuance over the past decade has made traditional municipal tax-exempt par call redemption features more prevalent and accepted in the taxable market. Develop an understanding of the market well in advance of the planned sale, including types of investors, structural features, and size requirements needed to attract investor interest.

For instance, a low-interest rate environment may minimize the long-term costs associated with issuing taxable debt relative to tax-exempt debt. Evaluate whether there are advantages to selling bonds outside of the U. Legal counsel familiar with particular international capital markets should be involved in order to review specific regulatory and disclosure requirements that may differ from U.

Also, governments must be sure they have sufficient staff time and expertise to manage taxable debt offered in the international marketplace. Allow sufficient time to educate investors who may be less familiar with state and local credit, about the offering and the issuer.

Evaluate the market for taxable state and local government bonds prior to the pricing process, including identification of comparable issues and interest rates, including the use of variable rate debt. This means that the issuer can choose to retire the entire value of the bond early, on the call date, and would likely do so if prevailing interest rates are lower than the bond's coupon rate.

Finally, municipal bonds are traded only on the over-the-counter market, whereas some corporate bonds are listed on exchanges. The most common type of municipal is called the general obligation GO bond. These bonds are not tied to a particular community project, and the issuer of the GO bond is obligated to make interest and principal payments on time, which makes them one of the least risky municipal investments.

Consequently, they also have lower yields. Another type of bond is the revenue bond, which is backed only by the revenue expected to be generated by the facility being built. Other types include special tax bonds and industrial revenue bonds, as well as variations on the general obligation bond.

Major types of municipal bonds. General obligation bonds: Backed by the full faith and credit of the issuing government and its taxing power. They are considered very low risk and thus offer the lowest yields. They are approved by voters. Revenue bonds: Secured only by a specified revenue source such as highway tolls or airport fees. They are considered somewhat riskier than general obligation bonds and thus usually offer higher yields. Commercial paper: Short-term debt issued by governments to meet cash-management needs, budget shortfalls, and the like.

Typically they are backed by a bank letter of credit and carry maturities of less than nine months. The yields offered are generally low due to their short maturities. Private activity bonds: Used to fund private pursuits that qualify under federal law as having a tax-exempt status. They are considered riskier than revenue and general obligation bonds and thus offer higher yields. May not be tax exempt. Municipal bonds usually have a yield several percentage points below the yield on corporate bonds of comparable maturity.

This means that a municipal bond can provide the same after-tax yield as a taxable bond paying a higher interest rate. If you are in a high tax bracket, the benefits of using municipal bonds in the bond portion of your portfolio are impressive.

You can easily calculate the comparable yield on a taxable investment, known as the taxable-equivalent yield see "Consider Taxable-Equivalent Yield". With thousands of municipal bond issues outstanding, keeping track of prices for each on a day-to-day basis is beyond the capabilities of news reporting organizations.

Consequently, you don't see specific municipal bond prices in a newspaper — you have to consult a bond dealer if you are interested in a specific bond price. In an attempt to make municipal bonds more attractive to individual investors, the municipal bond industry is starting to report regional pricing on municipal bonds to national news services. As a result, there will be some benchmark investors can use to learn how one bond compares to another. As with the prices of other types of bonds, municipal bond prices react to changes in interest rates.

This is why many analysts recommend holding short- to intermediate-term bonds, because they are less vulnerable to changing interest rates. Municipal bonds also pose credit risks — as became clear when several larger cities filed for bankruptcy following the most recent recession. Other risk variables are specific to municipal bonds, such as the potential for future changes in the tax law. Some of these risks are lessened by purchasing shares of a municipal bond fund, which are inherently diversified.