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.
Why is the interest on municipal bonds tax-free?
The most compelling economic argument for municipal bond tax exemption is that it encourages state and local governments to invest in infrastructure projects that benefit nonresidents.
What is the purpose of tax-exempt bonds?
Every state has a state-chartered bond authority. Healthcare facility authority, housing finance agencies, higher education facility authorities, and industrial development finance authorities are all examples of these. Energy efficiency retrofits for existing facilities owned by eligible borrowers are among the projects that are eligible for those powers. The federal tax code defines the following individuals as eligible borrowers for tax-exempt bonds:
Tax-exempt bonds typically have lower interest rates and longer tenors than taxable bonds, making them an ideal and appealing way for qualifying borrowers to fund energy efficiency or renewable energy projects.
The term “tax-exempt” refers to the fact that the interest component of bond debt service payments is exempt from federal and, in some cases, state and local income taxes. As a result, the interest rate will be lower than a taxable bond in terms of credit quality and bond length. Fixed-rate bonds with terms of 10 to 15 years are prevalent. Tax-exempt bonds also have a large market of potential buyers. The ability to sell bonds is always contingent on the borrower’s credit quality, however credit improvements can help the bond’s credit quality.
When clean energy finance initiatives target the eligible industries, state and municipal governments should consider tax-exempt bonds as a financing option because of the lower rate, longer duration, and deep buyer market (listed above). It is recommended that state and municipal governments meet with respective bond authority to discuss how they might engage in local or state financing initiatives.
Bond authorities, as public bodies, are often mission-driven and focused on employing their financial resources for the greater good. To accomplish state economic development goals, such as encouraging lending to small and medium-sized businesses, several authorities also issue taxable bonds and offer other financial products. Bond authorities can serve as a conduit for finance as well as a marketing partner; they already have loan portfolios and can, for example, approach their current borrowers with an offer of energy efficiency or renewable energy engineering evaluations and services, if they are available.
Low-cost funding is helpful in driving project development, but it must be combined with marketing and project development. Bond authorities and state and local government energy efficiency finance initiatives could establish natural alliances. Utilities, energy efficiency and service companies, end-user associations (for hospitals, higher education, private schools, and industry), and others can pool their resources to generate project deal flow and market energy efficiency/renewable energy finance products that the bond authority can arrange.
Private Placements Versus Capital Markets Bond Sales
Loans for energy efficiency retrofits of existing facilities are typically minimal, ranging from $75,000 to $150,000. When it comes to arranging funding, streamlining bond issuance procedures, managing transaction costs, and finding interested bond purchasers, these tiny loan sums might be difficult.
Bond authorities are, in general, conduits for financing rather than lenders. That is, they issue bonds, but bond purchasers must be found and the borrower’s credit must be approved. Bonds can be offered in the capital markets as a public sale with a credit rating from a bond rating agency like Fitch or Standard & Poor’s, or as a private placement to a bond purchaser without a credit rating. A private placement might be as small as $500,000 or as large as $1 million. For smaller bond offerings, certain authorities have established expedited methods.
A public bond sale’s minimum size is usually in the $10 million to $20 million range, if not considerably more. Credit improvements and letters of credit can frequently assist in obtaining a rating from the rating agencies. Some bond authority can fund projects with their own funds, then pool them and refinance via a bond issue. Alternatively, the bond authorities might collaborate with a partner financial institution to originate renewable energy loans, which could subsequently be pooled for refinancing via a bond sale.
Are tax-free bonds a good investment?
- Municipal bond interest is tax-free in the United States, however there may be state or local taxes, or both.
- Be aware that if you receive Social Security, your bond interest will be recognized as income when determining your Social Security taxable amount. This could result in you owing more money.
- Municipal bond interest rates are often lower than corporate bond interest rates. You must decide which deal offers the best genuine return.
- On the bright side, compared to practically any other investment, highly-rated municipal bonds are often relatively safe. The default rate is quite low.
- Interest rate risk exists with any bond. You’ll be stuck with a bad performer if your money is locked up for 10 or 20 years and interest rates climb.
Is it wise to invest in tax-free bonds?
Municipal bonds are an excellent method to keep your money safe while earning interest. The majority of them are tax-free at the federal level, and several are also tax-free at the state and local levels. Munis are frequently treated as an unique asset class, therefore understanding the fundamentals of muni bonds is essential.
When did municipal bonds become free from taxation?
Roads, bridges, airports, schools, hospitals, water treatment facilities, power plants, courthouses, and other public structures are examples of significant, expensive, and long-term capital projects for which state and municipal governments issue bonds. State and municipal governments can, and do, pay for capital investments using current income, but borrowing allows them to spread the expenses across numerous generations. Future users of the project pay a portion of the cost through rising taxes, tolls, fares, and other fees that help pay off the obligations.
To assist smooth out unbalanced financial flows, states and municipalities issue short-term loans or notes (e.g., when tax revenues arrive in April but expenditures occur throughout the year). They also issue debt for private companies (e.g., to build projects with public benefit or for so-called public-private partnerships).
HOW LARGE IS THE MUNI BOND MARKET?
State and local governments had $3.85 trillion in debt at the end of 2019. (figure 1). Approximately 98 percent of this debt was long term, having a maturity of at least 13 months, while only 2% was short term. As in previous years, states issued around 40% of municipal debt while local governments issued 60%.
Municipal debt has more than tripled in nominal terms since the mid-1980s, but the shift as a proportion of GDP has been less significant.
What Are the Main Types of State and Local Government Debt?
General obligation bonds are backed by a company’s “full faith and credit,” which includes the ability to tax. Future revenue streams, such as dedicated sales taxes, tolls, and other user charges generated by the project being financed, may also be used to secure bonds.
Generally, general obligation bonds require voter approval and are subject to debt-to-equity limitations. These rules and limits do not apply to revenue bonds or bonds secured by projected legislative appropriations. In 2018, revenue bonds accounted for 58 percent of state and municipal issuances, general obligation bonds for 36%, and private placements for 6%.
Who Holds State and Local Government Debt?
Households hold the majority of state and municipal bonds, followed by mutual funds (which also represent household investors) (figure 3). Until the Tax Reform Act of 1986 and subsequent lawsuits, banks and life insurance corporations were the most major municipal bond holders.
How Does the Federal Tax Exemption Work and What Are Proposals for Reform?
The federal income tax has exempted interest payments from municipal bonds from taxable income since its introduction in 1913. Interest on bonds issued by the taxpayer’s home state is usually free from state and municipal taxes. In Department of Revenue of Kentucky v. Davis, the US Supreme Court maintained states’ power to tax interest on bonds issued by other jurisdictions.
For a given degree of risk and maturity, state and local governments can borrow more cheaply than other debt issuers, such as companies, thanks to the federal tax exemption. As a result, the federal tax exemption acts as a federal subsidy for state and municipal infrastructure spending. This subsidy comes with a price tag of $28 billion in lost tax income in fiscal year 2020.
The federal tax exemption has been criticized as wasteful since it provides high-income taxpayers with more than the required incentive to buy municipal bonds. A high-grade tax-exempt municipal bond, for example, yielded 3.53 percent in 2018. A comparable taxable corporate bond yielded 3.93 percent. As a result, taxpayers with a federal tax rate of around 10% should be able to choose between the two types of bonds (the yield difference—0.4 percentage points—is roughly 10% of 3.93 percentage points). Anyone in a higher tax bracket earns a windfall, while the borrower receives no further advantage.
Because of this inefficiency, ideas to reduce the federal tax exemption have long circulated, most recently by former Vice President Joe Biden as part of his 2020 campaign tax proposals. However, whether states and localities respond by issuing more or fewer bonds, and whether bondholders respond by changing their portfolios toward taxable bonds or other investments, will determine the revenue benefit from eliminating or reducing the deduction (Poterba and Verdugo 2011). It’s also difficult to keep all key bond characteristics constant, such as risk, maturity date, fixed versus variable interest payments, and liquidity (Congressional Budget Office and Joint Committee on Taxation 2009).
Notably, the bond interest exemption has not been capped in any of President Donald Trump’s previous budget plans.
Are municipal debts subject to taxation?
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.
What is the distinction between tax-exempt and taxable bonds?
Tax-exempt bonds are not subject to federal income taxes, as the name implies, but they may have lower rates of return than taxable bonds. Bonds issued by the state government are normally tax-free, and those issued by a municipality or town may be tax-free as well.
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.
How do I go about purchasing tax-free bonds?
These tax-free bonds are available in both physical and demat form to investors. The subscription period for tax-free bonds is open for a limited time, and you must purchase these bonds within that time frame. If the bonds are purchased in tangible form, the investor must provide his or her Permanent Account Number (PAN).
Are municipal bonds preferable than certificates of deposit?
Tax-exempt municipal bonds (munis) are more appealing to individuals in higher tax rates in general. To compare municipal bonds to taxable bonds, you must first calculate the muni’s tax-equivalent yield. Municipal bonds have outperformed CDs, despite the fact that CDs are less risky.