Purchasing Municipal Bonds at David Lerner Associates

Investors may buy municipal bonds at prices above, below or at par value.

Municipal Bond Purchases
Investors have several buying options and may purchase municipal bonds at prices above, below or at par value. We will examine three scenarios here:

• Bonds purchased at a market discount.
• Bonds purchased as an original issue discount.
• Bonds purchased at a premium.

Municipal Bond Purchased at Market Discount
Market discounts can occur due to an increase in interest rates or a reduction in the credit worthiness of the issuer. The IRS has ruled that if an investor buys a tax-exempt bond at a market discount to par after May 1, 1993, the investor must pay ordinary income tax on the value of the discount just as if it were a taxable bond. This can be paid over the life of the bond or at maturity.

Municipal Bond Purchased at Original Issue Discounts
When an issuer issues a municipal bond below par, the entire discount is considered tax-exempt. The IRS considers this an issuer-based discount as opposed to a market-based discount. A common example of this is the zero-coupon municipal. The investor can incur a capital gain or loss upon sale of these bonds if the difference between what is paid is more or less than the original issue discount.

Municipal Bond Premiums
If an investor buys a tax-exempt bond at a premium, he must amortize the premium over the period he owns the bond. This amortization reduces his basis in the bond, but unlike a taxable bond, he can't deduct the amortized amount. The premium amortization is not deductible because the interest is not taxable.

Munis and Taxes

Sometimes investors will take advantage of changes in the economy by doing a municipal bond swap. If you swap a municipal that has fallen in price for a similar bond, you may take a deduction for the capital loss that may be used immediately. The new bonds must differ in at least two of the following three criteria:
	Issuer
	Coupon Rate
	Maturity Date
By changing these three criteria, you may satisfy the IRS "Wash Sale" rule which requires a swap into a substantially different security.

Swapping Into a Market Discount Bond
If you swap into a market discount bond, you may owe income taxes on the discount amount of the new bond depending on how it is liquidated in the future. However, as with taxable bonds, an investor can elect to defer this tax over the life of this municipal.

Swapping Into Par, OID or Premium Bonds

One approach when realizing losses in municipals may be to restrict reinvestment to municipals:
	Selling at par or slightly under par
	At premium to par
	That were issued at a discount thereby circumventing the tax rules on
market discount bonds

Municipal Bond Ratings
In the purest sense, the credit analysis of a General Obligation bond centers on two issues: (1) the municipality’s willingness to pay and (2) its willingness to pay its debts in a timely manner. The two main rating companies for municipal bonds are Moody’s and S&P. The basic difference between the ways that the two rating companies analyze bonds is that, while Moody’s concentrates on debt burdens and debt ratios, S&P focuses on the socioeconomic base of a community (e.g. per capita growth trends, total personal income). The Moody's ratings in the following ratings explanations are in parenthesis.

AAA (Aaa)
AAA (Aaa) - The highest rating assigned by Moody’s and S&P. Capacity to pay interest and repay principal is extremely strong.

AA (Aa)
AA (Aa) - Debt has a very strong capacity to pay interest and repay principal and differs from the highest rated issues only in a small degree.

A
A - Debt rated “A” has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse affects of changes in circumstances and economic conditions than debt in higher-rated categories.

BBB (Baa)
BBB (Baa) - Debt is regarded as having an adequate capacity to pay interest and repay principal. These ratings by Moody’s and S&P are the “cut-off” for a bond to be considered investment grade. Whereas debt normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal in this category than in higher-rated categories.

BB (Bb), B, CCC (Ccc), CC (Cc), C
BB (Bb), B, CCC (Ccc), CC (Cc), C - Debt rated in these categories is regarded as having predominantly speculative characteristics with respect to capacity to pay interest and repay principal. “BB” indicates the least degree of speculation and “C” the highest. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or market exposure to adverse conditions and are not considered to be investment grade.

D
D - Debt rated “D” is in payment default. This rating category is used when interest payments or principal payments are not made on the date due, even if the applicable grace period has not expired, unless S&P believes that such payments will be made during such grace period.

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