Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Private-Purpose Bond

What it is:

A private-purpose bond is a municipal bond that uses a significant amount of its proceeds to fund private activities or benefit private parties.

How it works (Example):

Let's assume Company XYZ wants to open a factory in ABC Town, which is economically depressed, but Company XYZ doesn't have the $100 million necessary to construct the factory. Because the factory could bring jobs to the area, ABC Town wants to do what it can to encourage Company XYZ to build the factory. So it might consider issuing municipal bonds and then lend the proceeds to Company XYZ so that it will build the factory. In this situation, ABC Town becomes more economically viable (and possibly collects more income and sales taxes from its residents now that they have jobs and disposable income), and Company XYZ gets to borrow money at rates below what the banks were offering.

Investors who buy the ABC Town municipal bonds may be in for a surprise, however, because the bond is a private-purpose bond rather than a public-purpose bond; that is, the proceeds don't go toward building schools, improving roads or other projects that have broad social value or put the citizens' interests first. Instead, the funds primarily benefit Company XYZ and its ability to generate a profit. Thus, the interest on the ABC Town municipal bonds is taxable. In some cases, a specific private-purpose bond issue might actually receive an exemption, making it tax-exempt.

Before the Tax Reform Act of 1986, municipalities faced tremendous temptation to act as commercial banks for private entities with projects that lacked substantial social benefit. The act, which made the private-purpose bond a taxable investment, quelled much of this temptation.
 

Why it Matters:

Municipalities often issue private-purpose bonds because they believe the investment it funds will stimulate the local economy. This is often the case for industrial-development bonds, for example. Although the company's products may not be of particular social significance, the jobs in the manufacturing plant are.

Some economists argue that private-purpose bonds slow economic output, because their lower coupon rates (lower than typical corporate debt) incent companies to settle for projects that create less profit.

Although one of the largest advantages of investing in municipal bonds is that the interest is usually exempt from federal taxes (and most state and local taxes if the investor lives in the state or municipality issuing the debt), this exemption only applies to public-purpose bonds. Thus, every municipal bond investor must read his bonds' offering statements and learn whether his bonds are public-purpose or private-purpose -- the statements must carry the opinion of a qualified tax attorney stating whether the interest on the bond is taxable or tax-exempt according to the Tax Reform Act of 1986 and other related laws. Municipal bond funds should also receive the same scrutiny, because if any of a fund's bonds are private-purpose, investors could be subject to taxes there as well.

Related Terms View All
  • Auction Market
    Though most of the trading is done via computer, auction markets can also be operated via...
  • Best Execution
    Let's assume you place an order to buy 100 shares of Company XYZ stock. The current quote...
  • Book-Entry Savings Bond
    Savings bonds are bonds issued by the U.S. government at face values ranging from $50 to...
  • Break-Even Point
    The basic idea behind break-even point is to calculate the point at which revenues begin...
  • Calendar Year
    If Company XYZ starts its fiscal year on January 1 and ends its fiscal year on December...