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What is a Tax-Exempt Bond?

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  • Written By: KD Morgan
  • Edited By: Bronwyn Harris
  • Last Modified Date: 15 November 2016
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There are wide variety of bonds available that fall into the tax-exempt bond category. The most commonly traded are municipal bonds (or munis) and Treasury securities. The munis are federal tax exempt and the Treasuries are mainly state and local tax exempt. It is important to be aware that your personal portfolio may mandate a portion of your interest be subject to alternative minimum tax.

Munis are issued by some government entity, whether it be local or state. Tax-exempt bond instruments issued by municipalities are either general obligation bonds or revenue bonds. General obligation bonds are issued for any project within the confines of the local or state authority. These bonds are usually the safest, with the lowest risk attached. Consequently, their interest rate might be below that of the revenue bonds.

Revenue bonds are issued for specific projects. Common projects are airport improvements, highway and transportation, hospitals, housing, local improvement and development (LIDS), parks and recreation, prisons, school districts and higher education, water, utilities, Veterans welfare, etc. Any improvement project is eligible to be funded with municipal bonds and are rated according to their risk factor.

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Interest payments also vary with tax-exempt bond instruments. There are zero bonds, which means that the interest payment is satisfied at the maturity of the bond. These bonds are purchased at a deep discount and mature at full value. The interest payment on the majority of other tax-exempt bond instruments is paid semi annually with the principal redeemed at maturity. Low risk bonds are insured by MBIA (the Municipal Bond Insurance Association).

The safest investments of tax-exempt bond instruments are U.S. Treasury securities. These securities are debt obligations issued and backed by the U.S. government. They are considered free of risk and consequently, they carry lower yields than other securities. Treasuries are state and local tax-exempt. They come in the form of bonds, bills, notes, strips (separate trading of registered interest and principal of securities), with the following options:

  • short-term bills

  • intermediate-term notes

  • long-term bonds

  • inflation-indexed securities or Treasury Inflation Protected Securities (TIPS)

Moody’s™ or Standard & Poor’s™ rate all tax-exempt bond instruments. These ratings range from Aaa to C or AAA to D accordingly. A “D” rating is already in default. Liquidation expediency is strongly linked to these ratings.

Most contracts include a call provision. This allows the tax-exempt bond to be retired before the maturity date. The bondholder will take advantage of this option when prevailing interest rates drop below the rate being paid by the bond.

The lower yields, interest rate fluctuations, and call provisions are the only risks involved in tax-exempt bond instruments. The quality, liquidity and security of these instruments, make them highly suited for the conservative investor.

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peterungar
Post 1

What law or court decision made municipal bond interest exempt from federal income tax? Why doesn't the law or court decision apply to AMT?

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