If a bond measure is proposed in a local election, a Tax Rate Statement may be provided to voters, detailing best estimates of the tax rate required to levy and fund the bond. In cases where no election is held, depending on applicable local law, voters may be entitled to petition the approval to referendum i. The issuer of a municipal bond receives a cash purchase price at the time of issuance in exchange for a promise to repay the purchasing investors, or their transferees, the bond holder over time.
Repayment periods can be as short as a few months although this is very rare to 20, 30, or 40 years, or even longer. The issuer typically uses proceeds from a bond sale to pay for capital projects or for other purposes it cannot or does not desire to pay for immediately with funds on hand.
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- Zero Coupon Municipal Bonds: Tax Treatment - TheStreet!
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Tax regulations governing municipal bonds generally require all money raised by a bond sale to be spent on capital projects within three to five years of issuance. Because of the special status of most municipal bonds granted under Section of the Internal Revenue Code, which provides that the interest on such bonds is exempt from gross income, investors usually accept lower interest payments than on other types of borrowing assuming comparable risk. This makes the issuance of bonds an attractive source of financing to many municipal entities, as the borrowing rate available to them in the municipal, or public finance, market is frequently lower than what is available through other borrowing channels.
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act , municipal advisors gained an increasingly important role in overseeing financial and legal circumstances surrounding the issuance of bonds.
Not Always Tax-Free: 7 Municipal Bond Tax Traps
Legally, the advisor is obligated to represent the interests of the issuer and serve as a source of financial advice. This entails offering advice on structuring, selling, and promoting bonds, as well as serving as the central liaison between other members of the financial team, especially the underwriters and credit rating agency.
Although municipal financial advisory services have existed for many years, municipal advisors have played a key role in the bond issuance process since the Securities and Exchange Commission enacted the Municipal Advisor rule in , which prohibits certain communications between issuers and broker-dealers unless one of four exceptions is met, one being that the issuer has retained an Independent Registered Municipal Advisor "IRMA".
After appointing a municipal advisor, bond issuers recruit a syndicate of legal professionals to serve as the financing team's bond counsel. The counsel works to verify the legal details of the issuance and ensure that the issuing agency is complying with all applicable laws and regulations. As the formal legal advisor for the deal team, the bond counsel will typically draft core documentation relating to bonds, including loan agreements, indentures, and other critical documents.
Along these lines, the bond counsel is also tasked with reviewing and advising on any legal issues that might arise, and interpreting how tax laws affect the issuance. For instance, the bond counsel will decide if an issuance is exempt from state or federal taxes. Once a municipal advisor and bond counsel have been established, they will work together to identify an underwriter that will manage the distribution of the bonds.
The underwriter is a broker-dealer that publicly administers the issuance and distributes the bonds. As such, they serve as the bridge between the buy and sell side of the bond issuance process. Underwriters connect issuers with potential bond buyers, and determine the price at which to offer the bonds. In doing so, most underwriters will assume full risk and responsibility for the distribution and sale of the bonds issued by the issuing agency. As such, underwriters play a central role in deciding the return and span of maturities, typically collect fees in exchange for their services.
If the price is wrong, the underwriter is left holding the bonds. Given the underwriter's role as a price marker, they also serve as a strategic partner to the issuing team, analyzing market conditions and trading, to help decide how and when the bonds should be sold.
Characteristics of Zero Coupon Municipal Bonds
In many cases there will be a co-manager who works with the underwriter to help provide the capital to buy the issuance. In large issuances, the underwriter s will often put together a syndicate or selling group. Brokers are the intermediate step between the underwriter and the actual bond holders, the cement-and-pavement financial professionals who answer orders for bond purchases. In most cases, underwriters will communicate and sell their maturities through multiple brokers.
The broker seeks to distribute their bonds from the underwriter at a small percentage profit. Given the current legacy systems of the bond market, the distribution and sale of bonds is an exceptionally manual process requiring tremendous labor overhead and paperwork. As such, most municipal bond brokers only sell to high net worth individuals and organizations seeking to buy large quantities of bonds.
Many of the people with direct ties to the impacted communities are therefore unable to contribute to their local governments, given little to no access to the profitable bond market. Municipal bond holders may purchase bonds either from the issuer or broker at the time of issuance on the primary market , or from other bond holders at some time after issuance on the secondary market.
In exchange for an upfront investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself see bond. Repayment schedules differ with the type of bond issued.
Municipal bonds typically pay interest semi-annually. Shorter term bonds generally pay interest only until maturity; longer term bonds generally are amortized through annual principal payments. Longer and shorter term bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, known as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.
Over the last decade many traditional and new market participants have begun to apply current technology solutions to the municipal market remedying many of the latent problems associated with many aspects of the municipal bond market. The emergence of products like small denomination municipal bonds, for example, is a result of new bond financing platforms. The general idea with modern platforms is to leverage technology to make the market more responsive to investors, more financially transparent and ultimately easier for issuers and buyers.
Many believe that, in doing so, more people will compete to buy muni bonds and thus the cost of issuing debt will be lower for issuers.
An International Study of Tax Effects on Government Bonds
One of the primary reasons municipal bonds are considered separately from other types of bonds is their special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt from gross income for federal income tax purposes, as well as state or local taxes depending on the state in which the issuer is located, subject to certain restrictions. Bonds issued for certain purposes are subject to the alternative minimum tax as an item of tax preference. The type of project or projects that are funded by a bond affects the taxability of income received on the bonds.
Interest earnings on bonds that fund projects that are constructed for the public good are generally exempt from federal income taxes, while interest earnings on bonds issued to fund projects partly or wholly benefiting only private parties, sometimes referred to as private activity bonds or PABs, may be subject to federal income tax.
However, qualified private activity bonds, whether issued by a governmental unit or private entity, are exempt from federal taxes because the bonds are financing services or facilities that, while meeting the private activity tests, are needed by a government. Purchasers of municipal bonds should be aware that not all municipal bonds are tax-exempt, and not all tax-exempt bonds are exempt from all federal and state taxes. The laws governing the taxability of municipal bond income are complex. At the federal level they are contained in the IRS Code Sections , , and rules promulgated thereunder.
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Additionally, special rules apply to certain types of investors e. For example, there is no IRS Code exemption for capital or other gains received from the sale of a municipal bonds and special rules apply for secondary market discount and original issue discount on municipal bonds. Each state will have its own laws governing what bonds, if any, are exempt from state taxes. For publicly offered bonds and most private placements, at the time of issuance a legal opinion will be provided indicating that the interest bonds are tax-exempt; these opinions do not customarily address collateral tax treatment.
Offering documents, such as an official statement or placement memorandum, will contain further information regarding tax treatment of interest on the bonds. Investors should be aware that there are also post-issuance compliance requirements that must be met to ensure that the bonds remain tax-exempt. The IRS has a specific section of their website, www. Municipal bonds have much higher interest rates compared to their FDIC-insured counterparts: CDs, savings accounts, money market accounts, and others. Over the last five years, the average interest rate return on municipal bonds has hovered around 4.
Unlike stocks and other non-dated investments, municipal bonds have fixed rates and are far less liquid. As a general rule, municipal bonds with longer time to maturity have higher coupon rates. Historically, municipal bonds have been one of the least liquid assets on the market. While stocks can be bought and sold within seconds on exchange platforms , given the current absence of widespread secondary market platforms for the exchange of stocks, municipal bonds are much harder to maneuver.
These minimum investment amounts previously barred many individuals from investing in bonds. The historical default rate for municipal bonds is lower than that of corporate bonds. The Municipal Bond Fairness Act HR ,  introduced September 9, , included a table giving bond default rates up to for municipal versus corporate bonds by rating and rating agency. The risk "security" of a municipal bond is a measure of how likely the issuer is to make all payments, on time and in full, as promised in the agreement between the issuer and bond holder the "bond documents".
Different types of bonds are secured by various types of repayment sources, based on the promises made in the bond documents:.
In addition, there are several other types of municipal bonds with different promises of security. The probability of repayment as promised is often determined by an independent reviewer, or " rating agency ". These agencies can be hired by the issuer to assign a bond rating , which is valuable information to potential bond holders that helps sell bonds on the primary market. Municipal bonds have traditionally had very low rates of default as they are backed either by revenue from public utilities revenue bonds , or state and local government power to tax general obligation bonds. However, sharp drops in property valuations resulting from the mortgage crisis have led to strained state and local finances, potentially leading to municipal defaults.
The prospect of Chapter 9 municipal bankruptcy was raised by the Controller of Harrisburg, although it was opposed by Harrisburg's mayor.
Holding Bonds Under the New Tax Law | Morningstar
Because municipal bonds are most often tax-exempt, comparing the coupon rates of municipal bonds to corporate or other taxable bonds can be misleading. Taxes reduce the net income on taxable bonds, meaning that a tax-exempt municipal bond has a higher after-tax yield than a corporate bond with the same coupon rate. A municipal bond that pays 6. The marginal tax rate t at which an investor is indifferent between holding a corporate bond yielding r c and a municipal bond yielding r m is:.