- 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.
Why do governments issue bonds?
Municipal bonds are debt securities issued by states, cities, counties, and other municipal bodies to support day-to-day obligations as well as capital projects like school construction, highway construction, and sewage construction.
Is it a smart idea to invest in municipal 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. 1 Municipal bonds, often known as munis, contribute to the development of infrastructure in your community.
What motivates banks to purchase municipal bonds?
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.
Is it possible to cash out municipal bonds?
The municipality pledges to pay you a predetermined sum after the bond matures in exchange for your purchase of a municipal bond. A matured bond can be redeemed at a local financial institution or directly from the municipality. You can also sell the bond on the secondary market before it matures, and you may be required to redeem the bond if the municipality calls it.
Why does a business issue bonds?
Bonds are one way for businesses to raise funds. The investor agrees to contribute the firm a specified amount of money for a specific period of time in exchange for a given amount of money. In exchange, the investor receives interest payments on a regular basis. The corporation repays the investor when the bond reaches its maturity date.
Are municipal bonds a high-risk investment?
- Municipal bonds are a wonderful option for consumers who want to keep their money while earning tax-free income.
- General obligation bonds are used to quickly raise funds to meet expenses, whereas revenue bonds are used to fund infrastructure projects.
- Both general obligation and revenue bonds are tax-free and low-risk investments, with issuers who are quite likely to repay their loans.
- Municipal bonds are low-risk investments, but they are not risk-free because the issuer may fail to make agreed-upon interest payments or be unable to repay the principal at maturity.
Opportunity cost
Municipal bonds’ tax advantages aren’t as valuable if you’re in a lower tax band as they are if you’re in a higher tax bracket.
If that’s the case, you could be better off putting your money into alternative investments for a larger return.
They may not be liquid
If you need money quickly, you should be aware that municipal bonds may have liquidity problems.
You might not be able to find an active market for your bonds, which means you won’t be able to sell them when you want at the price you want.
Is it wise to invest in municipal bonds in 2022?
The key drivers of the municipal market are all positive, therefore 2022 is expected to see ongoing robust demand for municipal bonds. Taxes are first and foremost. Investors are still concerned about increasing taxes and will do everything possible to avoid them, keeping demand high.