Municipal bonds are worth considering if your primary investing goal is to protect capital while receiving a tax-free income stream. Municipal bonds (also known as munis) are debt obligations issued by government agencies. When you purchase a municipal bond, you are essentially lending money to the issuer in exchange for a specified number of interest payments over a set period of time. When the bond reaches its maturity date at the end of that time, you will receive the whole amount of your initial investment back.
Is the government issuing municipal bonds?
- Municipal bonds (also known as “munis”) are debt securities that are issued by state and local governments.
- These are loans made to local governments by investors to fund public works projects such as parks, libraries, bridges and roads, and other infrastructure.
- Municipal bond interest is frequently tax-free, making them an appealing investment alternative for those in high tax brackets.
- General obligation municipal bonds (GO munis) offer cash flows through project taxes.
Are municipal bonds issued by banks?
Banks, like other investors, buy municipal bonds to take advantage of the tax-free interest they can earn. Commercial banks have traditionally been the primary buyers of tax-exempt bonds. With the passing of the Tax Reform Act of 1986 (the “Act”), presently known as section 265(b) of the Internal Revenue Code of 1986, as amended, banks’ demand for municipal bonds shifted (the “Code”).
The carrying cost (the interest expenditure incurred to purchase or carry an inventory of securities) of tax-exempt municipal bonds is not deductible under the Code. This clause effectively eliminates the tax-free benefit of municipal bonds for banks. The Code makes an exception, allowing banks to deduct 80% of the carrying cost of a “qualified tax-exempt obligation.” Bonds must be I issued by a “qualified small issuer,” (ii) issued for public purposes, and (iii) designated as qualified tax-exempt obligations in order to be qualified tax-exempt obligations. A “qualifying small issuer” is defined as an issuer that issues no more than $10 million in tax-exempt bonds in any calendar year. (1) “Bank qualifying bonds” are a term used to describe qualified tax-exempt obligations.
The Act effectively created two types of municipal bonds: bank qualified (also known as “BQ”) and non-bank qualified (also known as “NQ”).
Although banks are allowed to buy non-bank qualifying bonds, they rarely do so.
The rate they’d need to make the investment profitable would be similar to that of taxable bonds.
As a result, issuers can get cheaper rates by selling bonds to investors who will profit from the tax-free status. Banks, on the other hand, have a voracious need for bank qualifying bonds, which are in short supply. As a result, bank qualified bonds have a lower interest rate than non-qualified bonds.
Any difference in interest rates between bank qualified and non-bank qualified bonds has no bearing on the maturities acquired by banks.
The rate differential between bank qualified and non-bank qualified bonds has only been studied in a few research. According to WM Financial Strategies’ analysis of bond purchase proposals and bids, before to 2008, the rate differential on maturities acquired by banks was generally between 10 and 25 basis points (.10 percent to.25 percent). In general, banks bought bonds with shorter maturities (maturing in ten or fewer years). The rate gap soared to as much as 50 basis points during the credit crisis of 2008, and it was applied to maturities as long as twenty years. The rate differential shrank dramatically after the enactment of the American Recovery and Reinvestment Act of 2009, and was often invisible. (1) After these protections expired, the rate differential reverted to a 10-25 basis point range. The corporation tax rate was decreased from 35 percent to 21 percent with the enactment of the Tax Cuts and Jobs Act of 2017, diminishing the benefit of tax-exempt obligations for banks significantly. WM Financial Strategies believes the benefit of bank qualifying bonds is now less than 10 basis points, based on sales observations.
Any issuer proposing to issue less than $10 million in tax-exempt securities in a calendar year may consider bank qualifying the issue to save on interest costs. Issuers who need more than $10 million may be able to use bank qualification by issuing two series of bonds. For a $20,000,000 loan, for example, two $10,000,000 issues could be sold this year and one next year to get two bank eligible issues. Similarly, for a $25 million financing, $10 million in bank qualifying bonds might be sold this year and $15 million in non-bank eligible bonds could be offered next year.
Prior to separating an issue, a thorough cost analysis should be performed.
First, determine if the interest cost savings from bank qualification will be sufficient to balance the additional issuance expenses associated with two bond issues.
Second, in today’s volatile market, even a short delay in a bond sale can result in much higher interest rates, more than offsetting the rate reduction from bank qualification. For instance, from
From October 7 to December 6, 2010, interest rates increased by about 130 basis points (1.30 percent ).
Interest rates increased by 75 basis points from November 16 to December 16, 2016. (0.75 percent ). As a result, even a short-term postponement of a bond issue could be very costly.
(1)The $10 million bank qualifying bond maximum was increased to $30 million under the American Recovery and Reinvestment Act of 2009 (the “2009 Act”).
Furthermore, borrowers who took part in a pool or borrowed from a conduit issuer that issued more than $30 million in a calendar year were eligible for bank qualifying as long as their total tax-exempt financings were less than $30 million.
How do bonds function?
A bond is just a debt that a firm takes out. Rather than going to a bank, the company obtains funds from investors who purchase its bonds. The corporation pays an interest coupon in exchange for the capital, which is the annual interest rate paid on a bond stated as a percentage of the face value. The interest is paid at preset periods (typically annually or semiannually) and the principal is returned on the maturity date, bringing the loan to a close.
Is municipal bond interest taxable?
Residents of the issuing state are generally excluded from federal and state taxes on income earned from municipal bonds. While interest income is tax-free, any capital gains delivered to the investor are taxable. The Federal Alternative Minimum Tax may apply to some investors’ earnings (AMT).
Do municipal bonds pay monthly interest?
Municipal bonds (also known as “munis”) or tax-exempt bonds are examples of such bonds. The majority of municipal bonds and short-term notes are issued in $5,000 or multiples of $5,000 denominations. Interest on bonds is usually paid every six months (though some forms of bonds work differently), while interest on notes is usually paid when the note matures.
What are tax-free bonds and how do they work?
Municipal bonds (sometimes referred to as “munis”) are fixed-income investments that offer better after-tax returns than comparable taxable corporate or government issues. Interest paid on municipal bonds is generally excluded from federal taxes and, in some cases, state and local taxes as well.
Is there a chance of municipal bonds defaulting?
While the risk of default is modest, muni bonds are vulnerable to interest rate risk, or the possibility that rising rates may cause prices to decline. This is especially true for investors in municipal bond funds and exchange-traded funds (ETFs). If Treasury yields rise (implying that prices fall), muni bonds are quite likely to follow suit. Even if defaults stay low, investors’ principal value will drop.