How Do Tax-Exempt Bonds Work?

What is a Tax-Exempt Bond?

One form of investment that is very popular for investors in high tax brackets is a tax-exempt bond. A tax-exempt bond is a debt instrument that is issued by government agencies to fund certain projects. When an agency issues a tax-exempt bond, it is borrowing money from the investor. For the privilege of borrowing the money, the issuer of the bond will make interest payments to the bond holder until the bond reaches the date of maturity, at which point the debtor pays the bond holder the full face value of the bond. If the bond is callable, the debtor can pay the debt back early---however, he will often pay a small premium if he does this to make up for the loss of interest. Tax-exempt bonds fund projects government agencies do not have funding for, like projects to improve schools, roads and other public works projects.

Investors buy tax-exempt bonds directly from the local, city or state government when they are first issued. After that, the bond can be traded on the bond market. In either case, the bond can be purchased through a financial services company such as etrade, a financial adviser or stock broker.
The face value of the bond is the amount of the debt, not including interest, which is written on the certificate. This is what the debtor will pay to the bond holder when the bond matures. If the price of the bond is at face value, the price is called "par." If the investor pays more than the face value, it is called "premium," and if he pays less it is called "discount." The price of the bond is generally driven by the credit worthiness of the bond issuer and the competitiveness of the interest rate.
The interest rate on a tax-exempt bond is also called the coupon rate. This is the annual rate the debtor will be paying to the bond holder. These interest payments are exempt from local, state or federal taxes---or all three. This rate is determined when the debtor issues the bond and it usually stays the same throughout the life of the bond.

Bond anticipation or tax revenue anticipation notes are tax-exempt bonds that are short term, which mature in less than a year. General obligation bonds, private activity bonds, revenue bonds or assessment bonds are long-term bonds, which have a maturity date that is longer than one year. The maturity date is set at the time of issuance.

While tax-exempt bonds are generally safer than many other investment vehicles, they offer varying amounts of safety to investors. Like all investments, nothing is guaranteed and the investor could lose all of his money. While the agency issuing the tax-exempt bond guarantees the debt, the credit worthiness of the agency has a big effect on the safety of the investment. When deciding on a bond to invest in, it is a good idea to look at the rating of the bond. If a bond is rated as BBB, Baa or better, the bond is generally considered to be a fairly safe investment. AAA-rated bonds are very safe because they are fully insured by the agency issuing the bond.