Top 10 Key Concepts to Consider in a Tax-Exempt Muni Bond Purchase

What is a muni bond? It is a bond that is issued by a state or local government, or an agency of that government to raise money referred to as “capital”.

  1. What is the purpose for raising the capital? If it is for an essential service, like education or utilities, this is often a good credit. That means that there is a greater likelihood that the bonds will be repaid.  When individuals purchase high-yield bonds – also sometimes called junk bonds – they tend to focus on the yield and not on the possibility of non-payment, called a default.
  2. What sources of income back the bonds? Some bonds are backed by the full faith and credit of the taxing power of the issuer (general obligation bonds). Other bonds are backed by sources of revenue, such as electricity generation, or water and sewer revenue. Other sources of revenue may be restricted, such as limited obligation bonds, or tenuous source of revenue as in general appropriation bonds, where the legislature must vote to designate funds. Some bonds are funded by enterprise revenue, where the issuer will pay you back if the enterprise is successful.
  3. How do I judge the quality of the bonds? Municipal bonds are generally rated by Moody’s, Standard and Poor’s and sometimes Fitch Ratings. Ratings run from Aaa/AAA which is the best rating for all three issuers to D which is default. Ratings are not permanent. They can and do change, or are sometimes just withdrawn. Sometimes they have one rating only, sometimes two – which is best – or they may be non-rated – having no ratings at all. 
  4. How do I evaluate the issuer of the bonds? Ratings are the first cut in eliminating bonds. Second, look at the material events to see if the issuer has been filing the required documents, or if there are any legal issues posted, or the bonds are on negative or positive watch for a rating change.
  5. Can the bonds be redeemed (bought back by the issuer) before their maturity date? This is an option for the issuer to call in the bonds earlier than you might expect. There are three kinds of bond calls: Fixed calls, extraordinary calls and make whole calls.
    1. Fixed Calls: Municipal bonds may be issued non-callable for the first ten years, or the first call date can be at five years or anywhere in between.  After their first call date, most bonds then may be called on any interest payment date. 
    1. Extraordinary Calls: An extraordinary call allows a bond to be called at anytime based on unexpended funds or perhaps an extraordinary event. This kind of call is easily overlooked, and is very important if you are paying a premium.
    1. Make Whole Call: Found on taxable municipal bonds and corporate bonds, it is a call with a penalty for the issuer. It is a call that is not frequently exercised.
  6. What is the current rate of interest, commonly called “the coupon”? Municipal bonds are issued with a fixed rate of interest. Five percent (5.00) is a more common rate now, but the coupon varies based on the interest scenario in which it was issued.
  7. What is the sale price of the bonds? A bond may be sold at par (100) – the face value of the bond. It may be sold at a premium or a discount to the par value. 
    1. Par: One bond at par is valued at $1,000. Municipal bonds are sold in units of five.
    1. Premium: Any price more than $1,000. As the bond approaches its maturity date, the premium will decline to the par value. This cannot be taken as a tax loss.
    1. Discount: Any price less than $1,000. These bonds are subject to onerous tax rules, unless they are purchased in a tax-deferred account. The difference between the discount and par value may be subject to federal capital gains or ordinary income tax.

When interest rates rise, the price of the bonds fall. When the interest rate falls, the price of the bonds rise. This is called an inverse relationship. This should not concern you if you will hold the bonds to maturity.

  • How do bonds come to market? Bonds are sold by issuers in one of two ways:
    • Negotiated Issuance: A syndicate of underwriters come together to support the sale. Depending upon the buyers’ interest, the price may stay the same, raise or lower before the bonds are allotted.
    • Competitive issuance: An issuer offers the bonds at one moment in time and various syndicates of brokers bid against each other to purchase the entire issue.
  • Can I resell my bonds? There is a very active secondary market for individual bonds. There are computer platforms offered by big wire houses and bond brokers. Individuals, called Retail, banks and insurance companies are often active buyers.
  • Will the income from the bonds be tax-exempt for me? Tax-exempt municipal bonds may be exempt from federal taxes (see #7), but may be taxed by your home state. When you purchase an individual bond, you can ascertain if the interest payments will be tax-exempt for you. When you purchase a fund, the interest from many of the bonds may be subject to state taxes.

Unlike stocks, bonds are knowable. Read our book BONDS: The Unbeaten Path to Secure Investment Growth, John Wiley (2nd Edition).

©Hildy Richelson and Stan Richelson, July 10, 2024

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