Stripped municipal securities are created when the coupons are stripped off an interest-bearing security.
Stripped municipal securities are created when you take an interest-bearing security and strip the coupons off, thereby creating “straight zero-coupon” and “zero-coupon convertible” municipal securities. Straight zero coupon stripped municipals are purchased at a discount to their face value because they do not pay any current income. They are created from interest payment stripped from a tax-free municipal bond. An investor purchases these bonds at a discount to their face value, but does not receive the semi-annual interest payment that a holder of a typical municipal bond would receive.
Since these bonds are derived from a tax-free municipal bond, the difference between what the investor pays for the bond and what it matures for is usually federally tax-free. If the bond were issued in the investor’s home state, the interest may also be free of state tax.
This can be an important point because many zero coupon bonds can produce phantom income. In cases where investors purchase taxable zero coupons, they must pay taxes annually as the bond accretes in value or grows to its full face value. Investors can avoid such taxes by purchasing tax-free zero coupon bonds.
Zero coupon convertible stripped municipals are zero coupon bonds that convert (unless called by the issuer) to interest paying bonds at a predetermined point in time. These bonds are the corpus or body of the tax-free municipal bond that was stripped of some of its interest payments.
Investors should be aware that zero coupon bonds and zero coupon convertible bonds tend to be more volatile in the market place than interest paying bonds. If interest rates move up, the value of these bonds will decline, and if interest rates decline, their values tend to increase. Typically, over the life of these bonds, their values (especially in a static interest rate climate) tend to move to its full face value.
Investors should also be aware that interest payments from tax-free municipal bonds may be subject to the Alternative Minimum Tax depending on their tax bracket and income. Tax advisors would be able to verify if an investor is subject to the Alternative Minimum Tax.
David Lerner Associates and its employees do not provide tax advice. Investors should consult with their tax preparers and accountants regarding tax matters and when purchasing AMT bonds to ensure they fully understand the tax implications.
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