Tax-free Municipal Bonds and Rate of Return

When a state, municipality or county decides to offer municipal bonds, they are typically doing so in order to acquire the financing needed to fund various improvement projects within their area of administrative oversight. These projects can range from infrastructural improvements to increased funding for local schools. The scope of such improvements is, by nature, quite large. The municipal bond acts a debt security, providing investors with a safe and stable investment tool that guarantees a specific rate of return over the lifespan of the bond. Although municipal bond yields may not provide the most alluring rates of return, the stability associated with them is a viable trade-off.

Given the fact that municipal bonds are typically exempted from state/local taxes and fully exempt from federal taxes, this particular investment tool has become increasingly popular among individuals currently situated in the upper echelons of the federal/state income tax brackets. That being said, the municipal bonds interest rates attached to these investments can prove to be attractive for individuals from all points on the income spectrum.

Tip

Although many municipal bonds provide investors with tax exemptions, specific situations – such as the sale of a bond prior to its full maturation – may result in capital gains taxes.

Exploring Various Municipal Funds

A variety of municipal bond types are available, with the primary differences between them relating to the original source of interest payments on the bond and the source of repayment on principal funds.

A general obligation bond, or GO, is a type of municipal bond in which repayment is guaranteed through a variety of resources available to the local government issuing the debt security, including tax revenue. As a general rule, local governments tend to issue GOs when they are attempting to fund various public projects such as the construction of parks, infrastructural improvements on roads, bridges, etc., as well as the purchase of new equipment vital to the efficient operation of the city. Given the fact that the local government issuing the bond has, in some circumstances, the legal right to raise property tax rates in order to raise the funds needed for bond repayment, GOs are typically considered a highly stable form of debt security.

That being said, state governments have some degree of authority over how municipalities can choose to issue these bonds. For example, a state can determine whether or not local governments have the ability to issue unlimited-tax GOs, or if they are confined to limited-tax debt securities. In an unlimited-tax GO, local governments must do everything in their power – including raising property tax rates to 100 percent if need be – to repay the bond. This differs greatly from a limited-tax GO, where specific statutory limitations are mandated with respect to property tax increases.

Researching Revenue Bonds

Unlike a general obligation bond, revenue bonds are used to finance projects which themselves are capable of providing the revenue to pay back the borrowed funds. For example, a revenue bond would commonly be used to finance a project such as a toll road or a sporting arena. In either scenario, income produced from the finished project can be used to satisfy the terms of the debt security.

Although revenue bonds are used to fund projects which themselves are capable of generating income, the revenue bond issuance is considered more high-risk than that of a GO due to the fact that the former can only be backed by a specific revenue stream rather than the full effort of a local government. With that in mind, it is not uncommon for revenue bonds to feature a higher yield rate than GOs. At the time of issuance, the sort of financial backing is often described as part of the bond package.

For example, if revenue bonds are being issued to finance the creation of a new railroad system, the increased revenue provided by the improved rail transport network is considered the principal form of repayment. Because local governments are not entitled to raise property taxes in order to satisfy the conditions of these bonds, they are considered to be at higher risk of default than GOs. That being said, the increased risk associated with these bonds also has resulted in elevated municipal bond yields. For those who have the tolerance for risk, revenue bonds are capable of delivering a higher degree of return than general obligation bonds.

Evaluating Tax Treatments for Municipal Bonds

Both general obligation bonds and revenue bonds are exempted from federal taxes. In many situations, states in which the bonds are issued will also allow these investments to be exempt from taxation. Because of this, it is worth taking a second look at the perceived yield on these bonds. Although, at first glance, the yield on a municipal bond may appear less than that of a corporate bond, the net gain from the former may exceed that of the latter after tax is accounted for.

With this in mind, many investors may benefit from taking an additional look at potential municipal bond investments. Fortunately, many municipalities hire bond rating agencies to provide a credible assessment of the tax-free municipal bonds on offer in order to help boost investor confidence and spare them the trouble of extensive research. As the number of potential investors increases, this competition serves to lower interest rates and yield rates, which in turn benefits the municipality considerably. Those who are ready to explore the merits of a municipal bond should devote the time needed to properly assess who in the municipality is responsible for funding interest payments to investors and the capacity of the bond issuer to make good on their debt. Particularly when it comes to revenue bonds, due diligence prior to a purchase is absolutely critical.

Moving Forward With Municipal Bond Purchases

It is important to assess all factors that may influence your decision to purchase a municipal bond, including less visible taxation opportunities that may arise. For example, if you decide to sell your municipal bonds prior to their full maturity, you will be forced to pay capital gains tax on any profits realized. Issues such as this can quickly sap potential profits from these bonds unless individuals know exactly how to manage these assets.

It is strongly recommended that you consult with a financial adviser before committing to purchasing municipal bonds. Your advisor can help you determine whether or not these bonds represent a viable investment strategy based upon both your long-term and short-term financial goals. Additionally, an expert in such bonds may be able to help direct you to appealing investment opportunities based upon the ratings provided by credible bond rating organizations.

Video of the Day

About the Author

Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.


Zacks Investment Research

is an A+ Rated BBB

Accredited Business.