There are three reasons why purchasing municipal bonds is considered a "bad play" for bank investment portfolios:
(1) Corporate and individual tax rates have declined. This has lowered the tax equivalent yield and the saleability value.
(2) Banks' interest expense deduction for carrying tax exempts purchased after Aug. 7, 1986 has been taken away-the "TEFRA disallowance."
(3) An alternative minimum tax has been imposed on corporations. Pros. At first glance, these events suggest there may be little point in purchasing municipal bonds.
Actually, there are several reasons why tax exempts still make sense. They include the following:
1) Municipals issued after Aug. 7, 1986 by municipalities that do not issue more than $10 million of bonds or loans in any one year require only a 20% interest expense disallowance. Given a cost of funds rate of 8% and a 6% municipal bond face yield, the tax equivalent yield of 4.97% under the 100% disallowance treatment rises to 8.27% under the 20% interest disallowance rate.
(2) Municipal bonds hedge the bank against tax rate risk, the risk that tax rates will be legislated higher. Tax equivalent yields are greater, the higher the tax rates go. For example, given 20% interest disallowance, 8% cost of funds, and a 6% municipal bond face yield, at 34% tax rates the tax equivalent yield is 8.27%. However, if the tax rate is 46%, the tax equivalent yield increases to 9.75%.
(3) Long-term municipal bonds are generally fixed-rate instruments and should be viewed as desirable during a failing rate environment for asset/liability management gap report purposes.
(4) Because of the method required to compute the 20% interest expense disallowance, as interest rates fall, the tax equivalent yield on municipal bonds increases. Thus, municipal bond holdings have an added benefit for asset/liability management of the bank's net interest margin. This benefit probably should be reflected in preparing gap reports, perhaps by weighting municipal securities by a factor less than 100%; say, 95%. For example, given the 20% interest expense disallowance and a 6% municipal bond face interest yield, if the bank's cost of funds is 8%, then the tax equivalent yield is 8.27%. However, if the bank's cost of funds falls to 6%, the tax equivalent yield rises to 8.47%.
(5) If your choice in municipal bonds is to hold local municipal issues, to the extent those issues represent the funding of projects that benefit the community, such purchases can be used by the bank to help demonstrate it is fulfilling its Community Reinvestment Act requirements.
An example of how to calculate the tax equivalent yield of a municipal bond follows:
Stated municipal bond rate 6%
TEFRA disallowance 20%
Cost of funds rate 8%
Statutory tax rate 34%
Pretax Income from Municipal:
6% Face rate
(1 - tax rate of .34)
= 9.09% 9.09%
* TEFRA 20% Interest
8% Cost of funds
x 20% Interest expense
x .34 Tax rate
= . 544 After tax cost
./. (1 - tax rate of .34)
= 0.82% Pretax cost (0.82)%
Tax equivalent yield 8.27%
Suggested program. if you decide to purchase municipal bonds, here is one possible program:
Only purchase tax exempts from municipalities that do not issue more than $10 million in bonds or tax-free loans in any one year. As I mentioned before, this means the bonds are subject to 20% interest expense disallowance, rather than 100%.
Some reliance can be placed on the opinion clause on the front page of the bond's offering statement, which states that interest on bonds is exempt from federal income taxes. …