Municipal bonds are debt obligations of a local government (e.g. city or county) or one of its agencies, which can be issued for such projects as the building of schools, medical facilities, water and sewer systems, roads and other purposes that benefit the public. When the government entity borrows money for such purposes they promise to pay interest on a semi-annual basis and return the principal sum either at maturity or on a date on which the bond can be called in early (usually call dates are ten years from initial issuance). For purposes of this article let’s concentrate on tax-exempt bonds which offer income that, because it is exempt from federal, state and city taxes, is commonly known as triple tax-free income. A resident of New York who purchases a bond with after-tax dollars issued by a NY government entity is exempt from paying taxes on the interest received. The purchase of Puerto Rico, Guam and Virgin Islands Bonds are also triple-tax-free.
When purchasing a bond, one needs to familiarize themselves with credit ratings, maturities, call features, and sinking funds. Two major risks involved in the purchase of bonds are credit risk and interest rate risk, which will affect its marketability if the bond is sold before maturity. The rule of thumb is that the higher return means higher risk.
A bond buyer would also need to ascertain if they are subject to Alternative Minimum Tax (AMT) which is a federal tax that requires wealthy individuals to pay a minimum tax.
Individual bonds can be generally bought in blocks of $5000 denominations, and can trade at par, a premium, or a discount to its face value.
A bond fund is an alternative to buying individual bonds, and offers diversification of bond issues. A bond fund can include in their portfolio general obligation bonds, revenue and industrial development bonds, hospital bonds, healthcare bonds and, tobacco master settlement bonds. Certain fund families offer limited or short term maturities, or AMT-free bonds for investors who are subject to alternative minimum tax.
In the current interest rate environment, tax free municipal bonds offer exceptional value when compared to other income vehicles such as treasury bills, CDs, or corporate bonds. A treasury going out ten years yields a paltry 1.72%. This is the lowest yield on ten year treasuries since the Eisenhower administration. Thirty year treasuries yield 2.81%, and five year CDs, 1.49%. Although some real estate investment trust can fetch upwards of 13%, they are a riskier investment than the others discussed here. A ten year Puerto Rico general obligation rated BAA1/BBB yields 3.793% with a taxable equivalent of 5.2% in the 28% tax bracket. New York City GOs whose term extends to 2035 yields approximately 4.4% and Puerto Rico GOs, generally cheaper than New York paper, will yield approximately 4.8% to 5%.
While some investors choose to get the highest possible return by buying long term bonds, other choose to stay short term so as not to see their principal go down when and if rates go up. Some investors hedge their portfolios by building a ladder and spreading out the maturities. An example of this would be to buy 3,5,10,15,20,25, and 30 year maturities, and re-evaluate when each bond matures.
Robert Kirschner is a registered representative offering securities through Walnut Street Securities Inc. (“WSS”) Member Finra, SIPC. If you would like to learn more about income-producing financial investments, you can contact Mr. Kirschner at [email protected], or by phone at 212-769-3411.