1. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? A municipal bond is a debt instrument issued by a state, county, city, or other non-federal governmental agency. –They are also known as tax-exempt bonds. –They typically pay a fixed rate of interest. –Generally, interest from these bonds is exempt from federal income tax and may also be exempt from state, county, and local taxes as well. –Some so-called private purpose or private activity municipal bonds are issued in taxable form.

2. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 What is it? Three types of municipal bonds –General Obligation Bonds Backed by the full faith and credit of the issuer’s taxing authority –Have a strong claim on the tax revenues of the taxing authority –Generally considered the safest form of municipal bonds Issued to finance the general operations, functions, and programs of the issuing authority –Revenue Bonds Issued to finance municipally owned toll roads, toll bridges, and other public capital projects or public services User fees or specific assessments are intended to repay the debt. Bondholders rely upon the adequacy of the fees or assessments received by the municipality to pay interest on the bonds. Usually junior to general obligation bonds –Greater risk of default

3. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 What is it? –Private Purpose Bonds Also known as “private activity” bonds Issued to finance certain activities that do not constitute the normal activities or functions of government –Often used in the trade or business of persons other than state or local governments The interest on these bonds is not tax-exempt for federal income tax purposes. –Usually exempt from the issuing state or local government’s income tax. –Certain private activity bonds used for qualified purposes may be exempt from federal income tax. »Industrial development »Student loans »Qualified and veterans’ mortgages

4. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 When is the use of this tool indicated? When the investor’s tax bracket is high enough that the lower yield of a tax-exempt instrument results in a higher after-tax rate of return than would be produced by a comparable taxable investment –The investor’s tax bracket includes any state and local taxes. When a steady and consistent flow of income is desired When a secure and relatively conservative investment is indicated When an investor anticipates holding the investment for a minimum of 3 to 5 years

5. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Advantages Income from these bonds is exempt from federal income tax –They may provide a higher after-tax return than alternative investments producing taxable income. –The higher an investor’s tax bracket, the greater the advantage of tax-exempt income. The benefit of the tax-free bond would be reduced for investors in lower brackets. –Formula for comparing tax-free with taxable yields: [Tax free return / (100% - Tax rate)] X 100% = Taxable Equivalent Yield

6. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Advantages Income from municipal bonds may also be exempt from state, county, and city income taxes. –Generally, the income is exempt from taxation only within the state where the bond was issued. Principle and income are relatively safe. –A “general obligation” municipal bond is a debt obligation that has a strong claim on tax revenues. The payments on most tax-exempt municipal bonds have priority over many other government obligations. “Revenue bonds” must be paid from specific revenues rather than general taxes.

7. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 Disadvantages Municipal bonds provide minimal protection against inflation. –The fixed income may not keep pace with an increasing cost of living. –The bond principal may not provide the purchasing power at maturity or sale that would have been available through an alternative investment. Bond prices may fluctuate with changes in market interest rates. –When interest rates rise, bond values typically decline. –If interest rates drop, bond prices generally rise.

8. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 Disadvantages There may be a limited market for municipal bonds. –Particularly applies to those issued in small amounts that are not traded actively. –An investor may have to accept a lower price if he/she wants to sell the issue quickly. Tax-free bonds can seldom be purchased directly for less than $5,000. Bid-ask spreads are often quite large and can have a significant effect on the total return to the investor. –The spread is the difference in the price a broker is willing to pay a seller and the asking price for the same bond.

9. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Tax Implications Interest income is exempt from federal income and often state and local taxation. Capital gains (or losses) realized on the sale of these bonds are subject to normal capital gain (or loss) treatment. –Special rules apply to municipal bonds having original issue discounts and bonds purchased in the secondary market at a price other than par. Investors are required to amortize any discount from par that they paid for a bond over its remaining life and include this amount in their return as ordinary income.

10. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Tax Implications Gifts of municipal bonds are generally subject to federal (and in many cases state) gift taxation. –A bequest of such bonds is subject to the federal estate tax as well as applicable state death taxes. Interest paid on certain private purpose bonds and arbitrage bonds issued by or on behalf of state or local governments is not tax-exempt. –For tax purposes, they are government bonds taxed like Treasury bonds. –Interest on certain categories of private activity bonds is tax- exempt.

11. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Alternatives Taxable bonds generating a comparable, or higher, after-tax yield Single premium deferred annuities providing a fixed annual payment Certain preferred stock with a fixed dividend

12. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 Where and How do I get it? Municipal bonds can be purchased by calling a brokerage firm or contacting a bank, savings and loan, or savings bank. Each dealer in bonds establishes a price based on cost and demand. –Larger dealers set prices based on the amount for which similar lots of the same bonds can be sold or acquired. –There is no national auction for municipal bonds as there is for stocks. It is important to check the yield to maturity of each bond.

13. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 Where and How do I get it? Greater diversification is available through municipal bond unit trusts and municipal bond mutual funds. Municipal bond unit trusts –Fixed portfolio: the underlying bonds do not change/are not managed. Increased safety through diversification Professional selection Security – The unit trust safeguards the securities themselves. Convenience – Interest and principal are collected by the unit trust and paid out on a regular basis or automatically reinvested. –Unit trusts are “self liquidating.” When assets drop below approximately 20% of the original investment, the fund ends and unit holders receive their share of the current price of the portfolio. –They are best for long-term holdings when a certain fixed income is desired.

14. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 Where and How do I get it? Municipal bond mutual fund –These funds are similar to municipal bond unit trusts, except that the underlying portfolios are “managed.” There is a regular sale and purchase of bonds to take advantage of changing market conditions. –Shares of a municipal bond fund are bought and sold on the open market. The prices fluctuate with the changing value of the underlying securities. –If an investor expects to sell in a relatively short period of time (for example, three years), a managed tax-exempt fund is a better choice than a unit trust.

15. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 What fees or other acquisition costs are involved? When purchased directly from a broker or bank, there is a sales charge or brokerage commission. –Fees will vary depending on the amount invested and the number of bonds purchased. –Some institutions charge fees based on the number of bonds, while others calculate fees on the total dollars invested. Range from $5 to $10 per bond If purchased through a unit trust, a “load” (sales charge) of 3.5% to 5.0% is typically added to the value of the purchase. –Less money is at work for the investor –The “load” tends to penalize an investor who liquidates his/her holdings quickly.

16. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 What fees or other acquisition costs are involved? Purchasers of municipal bond mutual funds may pay a sales charge or may select a fund with no sales charge. –A fund with a sales charge is known as a “load” fund, while a fund with no sales charge is known as a “no-load” fund. –Both types typically charge an annual management fee. Ranges from.5% to 1.0% of the net asset value This fee is deducted from the assets of the fund itself and is not paid directly by individual investors.

17. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 How do I select the best of its type? Quality rating of each bond –Bond ratings can be found on the internet or in a local library through services such as Standards and Poor’s, Moody’s, and Fitch’s. –Ratings of AAA or Aaa indicate the highest quality bonds, while those rated CCC or lower are quite speculative. An “A” rated bond will be safer and yield only slightly less than a lower quality issue. Current Yield –The coupon amount divided by the investor’s cost Yield to Maturity –The coupon return plus gain or minus loss at maturity

18. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 How do I select the best of its type? Purchasing a bond issued in the investor’s state of residence may result in a higher after-tax yield. Select a maturity date of 10 years or less. –If two bonds have the same quality rating, the bond with the shorter maturity date will typically have greater price stability (though perhaps a lower yield as well). Schedule maturities according to projected cash flow or capital needs. Search for large issues of general obligation bonds of state governments, and revenue bonds of large, well-known authorities. –They are more marketable and will be easier and less costly to sell quickly.

19. Municipal Bonds Chapter 5 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company19 Where can I find out more about it? Moody’s Municipal Bond Guide, Standard and Poor’s Bond Guide, or Fitch’s rating service –Available at a local library and on the internet Major brokerage firms and banks BondsOnline (www.bondsonline.com)