Tax Aspects of Municipal Bonds

Article excerpt

Municipal bonds are one of the most popular ways to shelter income from taxes because the interest they pay is tax-exempt on the federal level. (Some states and cities also exempt interest on bonds issued within the state or city.) In the past, most municipal bonds were held by large institutional investors. Today, approximately 70% are held by individuals. This makes it essential for CPAs who provide financial planning services to be familiar with the tax consequences of municipal bonds and when it is appropriate to recommend them.

Because municipal bond interest is tax-exempt, yields are lower than those on comparable taxable bonds. To determine whether a particular investor would benefit from investing in municipal bonds, CPAs must convert the tax-free return to an equivalent taxable yield, as described in the sidebar on page 52.

In addition to yield considerations, this article provides an overview of municipal bond investments that includes the risk factors and tax consequences.

ARE THEY RISK FREE?

Investors should evaluate municipal bond risks, including credit risk, interest rate risk and--in some cases--call risk.

Credit risk. This is the possibility the bond's issuer will not make interest or principal payments. Municipal bond defaults have received considerable attention because of the troubles in Orange County, California. An easy way for CPAs to help clients evaluate a bond's credit risk is to refer to Moody's or Standard & Poor's credit ratings. The highest ratings are Aaa or AAA respectively, with lower ratings indicating decreased credit quality. Securities with ratings of A or above from either service generally are considered investment-quality bonds.

Although the most commonly cited default rate for municipal bonds is 0.5%, evidence suggests default rates vary widely. A recent study found the default rate among bonds with an A rating was 1.15%; among BBB-rated bonds it was 1.4% and among unrated bonds, 3.07%. Defaults also tend to occur less frequently with general obligation bonds (backed by the issuer's full faith and taxing authority) than with revenue bonds (backed only by a specific project's revenues).

Investors can minimize their exposure to credit risk by investing only in rated bonds. They also should decide whether the higher yield offered by lower-rated bonds is worth the increased risk. Diversifying by holding bonds of several different issuers (avoiding a single region or state) also can reduce credit risk by lowering a single default's impact on the portfolio. Insured or prerefunded bonds also limit credit risk. (Private insurance guarantees principal and interest payments on insured bonds; prerefunded bonds are secured by a securities portfolio held by the issuer.)

Interest rate risk. This is the risk that changes in market interest rates will have a negative impact on a bond's value. Rising interest rates have a negative impact on municipal bond prices, falling rates have a positive effect. The longer the tune to maturity, the greater the impact. Accordingly, investors can reduce interest rate risk by investing in bonds with short- and intermediate-term maturities and holding them to maturity since they will receive the face amount at that time regardless of interest rate changes. Interest rate risk can be further mitigated by staggering bond maturities so a portion of the portfolio matures each year. The proceeds then can be reinvested at the prevailing rate so at least a portion is always invested at current rates.

Call risk. Municipal bonds are issued with provisions that allow the issuer to call (redeem) the bonds at specified prices after a certain period. Bonds are most often called during periods of falling interest rates--when the issuer can issue new bonds at a lower rate--leaving investors to reinvest at the lower prevailing rate. To mitigate call risk, investors can either avoid bonds with call provisions or buy those unlikely to be called--those with a stated interest rate considerably below the current market rate. …