The interest paid on corporate bonds is considered income, so it’s taxed. To encourage investors to lend money to cities, towns and states to pay for public projects — like schools, highways and water systems — Congress exempts municipal bond interest from federal income taxes.
If an investor were considering both a corporate bond and a municipal bond that paid 6 percent interest, the obvious choice would be the municipal bond. But the choices are seldom that simple. High-rated municipal bonds usually have a much lower yield than corporate bonds, because they have a tax advantage. Thus, municipal bonds, commonly called munis, usually appeal mostly to investors in the highest tax brackets, where the tax exemption provides the biggest tax savings.
Municipal bond interest is also exempt from state tax (and city tax where it applies) for investors who live in the state where the bond is issued. A person in California, for example, would pay no California income tax on bond interest earned on a Los Angeles bond. But someone from Maine who bought the Los Angeles bond would have to pay Maine tax on the interest income. Neither investor, however, would have to pay federal tax on the interest.
When states, cities or towns want to offer new bonds, there are two ways to get them to market. They can negotiate an arrangement with a securities firm to underwrite the bond or they can ask for competitive bids. A competitive bid means the issuer works with the lowest bidder to sell the bonds. A negotiated agreement takes other factors into account.
Since the mid-1980s, most offerings — up to 80 percent — have been negotiated. The main advantage is a guaranteed presale. The potential problems are the opportunity for manipulating the deal to the advantage of the underwriter at the expense of the taxpayer who foots the interest bills and the possibility of political kickbacks. In fact, in the past there have been allegations and investigations into this very activity around the country. On the other hand competitive bids are free of those problems, but may rule out developing a strong working relationship that could benefit issuer.
Some municipal bonds are insured by the American Bond Assurance Corporation and some are insured by the Municipal Bond Insurance Association. Yields on insured bonds can be as much as 2 percent cheaper and the bonds get a much higher rating. But the insurance companies are very selective in choosing their risks.
“The Blue List” publishes every business day the municipal offerings of broker-dealers. In particular, it gives the dollar volume of the total municipal offerings advertised for sale. “The Bond Buyer” is perhaps the most important publication devoted to municipal securities. Among its features are indices of municipal bond prices, listings of proposed bond issues, the placement ratio for the week (the percentage of new municipal issues sold during the week) municipal news, the 30-day visible supply of new issues and finally, invitations to bid on new municipal issues.
In any case, municipal bonds can be a worthwhile investment; if you do the research to find out if what you are buying makes sense compared to buying a non-municipal type bond. Often it comes to comparing yields, maturity and ratings — which is often a numbers game. And remember; take inventory of your investment objectives, attitudes and risk posture before making any investments.
Quote of the week: “If principle is good for anything, it is worth living up to.” — Ben Franklin
Bart Ward is the chief executive officer of Ward & Co. Ltd.. an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.