How Does a Tax-Free Bond Work?
Other People Are Reading
-
What's a Tax-Free Bond?
-
Most bonds are not tax free. Some, such as Zero Coupon bonds, even force an investor to pay taxes on money they haven't received yet, based on an annualized yield that isn't realized until maturity. Corporate bonds aren't tax free, either. In fact, the only bonds that receive special tax considerations are the ones that are issued by state and local governments.
Most governments issue bonds to fund very large or long-term expenses, for things such as infrastructure development or land acquisition. These municipal bonds, sometimes called "munis," are not taxed by the federal government. This means the regular coupon payments made to the bond holder until maturity do not count as taxable income on a federal tax return, and do not risk raising an investor's tax bracket. In almost all cases, a municipal bond will also be tax-exempt for residents of the state in which it was issued, even if it's a local, not a state, government issue. Local taxes will not be assessed against interest earned on the bond if the holder is a resident.
Pricing
-
Because municipal bonds carry these tax exemptions, they trade at a lower yield than securities of similar creditworthiness and maturity. This makes them far more attractive to investors who are eligible to receive the tax benefits than to those who aren't. As a result, municipal bonds are usually marketed locally and advertised at their tax-equivalent yield, which is the yield of the bond including the tax savings. At the tax-equivalent yield, municipal bonds can represent a higher return than similarly maturing federal and highly rated corporate debt.
-
Other factors
-
Like Treasuries, most but not all munis are backed by the taxing power of the state or local government, which is generally considered less risky than some corporate bonds. These are called general obligation bonds. Other municipal bonds may be linked to specific revenue streams, such as tolls, which may or may not materialize as expected.
As a result, issuers of tax-free municipal bonds usually must pay to acquire bond insurance to obtain a triple-A rating for their debt. The system of assigning credit ratings and the unregulated nature of credit insurance received serious scrutiny during the credit crisis of 2008. During March of that year, Moody's, a ratings agency, announced it would change its policy and begin to rate municipalities by the same criteria it uses for corporate bonds. This change makes borrowing cheaper for state and local governments by eliminating the need for bond insurance.
-
Resources
- Photo Credit Sascha Bruck
