Why do bonds exist?
Public improvement projects such as streets, sewers, highways, bridges, mass transit, hospitals, schools and other public works require large sums of capital. To finance these projects, municipalities and municipal agencies borrow money by issuing bonds.
Why are municipal bonds exempt from taxes?
Since the enactment of the Federal Income Tax Amendment in 1913, the Internal Revenue Code has provided a specific exemption for municipal bonds. Municipal bonds are free from Federal, state and city income taxes for local residents. For example, if a New York City resident purchases any type of New York tax-free bond, that income is exempt from Federal, New York State and New York City income taxes. This is what we mean by triple tax free.
Some of the major benefits of owning municipal bonds are:
- History of Payment: Research shows that over 99% of all municipal bonds have paid as promised.*
- Tax-Free Earnings: Interest earned from municipal bonds is exempt from Federal income tax and generally from state and municipal taxes for local residents.
- Fixed Income: Since you typically choose the maturity dates of between one and 30 years, municipal bonds allow you to plan for both current and future income. If held to maturity, the investor locks-in the income for the lifetime of the bond. For example, if the investor purchases a $10,000 bond with a 5% coupon, he will receive $500 a year for the lifetime of the bond.
- Liquidity: The large and active over-the-counter trading market for municipal bonds gives you the opportunity to sell your bonds at market value at any time.
- Growth: Certain bonds can be purchased at a discount which allows for capital appreciation if held to maturity.
- Collateral: Historically, municipal bonds are excellent collateral, enabling investors to borrow against their investment.
Bond prices move inversely to interest rates. Long-term bonds are more exposed to interest rate risk than short-term bonds. Investors who decide to sell prior to a call maturity date may receive more or less than their original investment depending on market conditions and any mark-ups or mark-downs to the price of the bonds.
What types of municipal bonds are there?
There are various types of municipal bonds, each issued for specific purposes.
- General Obligation Bonds: Issued directly by state or local governments or their agencies to meet essential government functions such as schools and highway construction. These bonds are backed by the issuer’s pledge and its full faith, credit and taxing power to meet interest and principal payments.
- Authority and Agency Bonds (Revenue Bonds): Created by states, counties, cities or a combination to perform specific functions such as the operation of bridges, tunnels, water or electric systems. These bonds pay interest and principal from the revenue generated by the facility.
- Housing Bonds: These issues are secured by mortgage repayments on single family homes or multi-unit rental buildings.
- Industrial Development Bonds: Made available by communities to encourage the construction of private purpose facilities such as factories and airports. These bonds are usually subject to the Alternative Minimum Tax.
What are insured bonds?
Some bonds are guaranteed by the issuer as well as having insurance purchased from an outside bond insurance company. The insurance applies to the timely payment of principal and interest. The value of the bonds is not insured and is subject to market fluctuation.
What are zero coupon bonds?
These are bonds that are bought at a discount. Zero coupon bonds pay no annual interest. However, at maturity, they grow to full face value. There may be a substantial gain or loss if zero coupon bonds are sold prior to maturity.
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