3 Types of Municipal Bonds Boasting Tax-Free Returns
If you've ever had a job with a terrible commute, you know that road construction is like glitter -- once it gets on a city, it's almost impossible to get rid of, and it shows up everywhere.
Roadwork, of course, is just one kind of public works project that costs the average city millions of dollars. Usually, cities don't have that kind of coin lying around with nothing to do, so they borrow the money.
And one way to do that is to issue municipal bonds.
What are Municipal Bonds? Are They Tax-Free?
Municipal bonds give people like you the chance to lend money to cities and other municipalities. As the lender, you get one particular perk: The interest payments you'll receive are often exempt from federal, state and local taxes -- especially if the investor lives in the state or municipality issuing the bond (Capital gains on municipal bonds are taxable, however).
For the most part, investors in high tax brackets can save a bundle in taxes by buying municipal bonds instead of "regular" bonds. This is why there is usually stronger demand for municipal bonds in high-tax states and how municipal bond issuers get away with offering bonds that have lower yields than taxable bonds.
The upside of lower yields is that they encourage governments to undertake new projects. Which brings us back to the lovely traffic jams.
But however you feel about the traffic jams that municipal bonds may indirectly create, here are three little-known types of municipal bonds that could give you tax-free returns.
1. General Obligation Bond
A general obligation bond ("GO bond") is a municipal bond that finances a city's overall operations and public works. That is, the projects funded by the bonds don't generate revenue (such as parks or streetlights). Voters usually have to approve GO bonds. GO bonds usually have $1,000 or $5,000 face values and mature in five to 30 years. They typically pay interest semiannually, although some are zero-coupon bonds.
Municipalities typically issue GO bonds the same way any other bond is issued: through an underwriter that gives a written prospectus to buyers and facilitates a competitive bidding process. After municipal bonds begin trading, bond dealers across the country earn money by acting as intermediaries between buyers and sellers. Most people buy munis through a broker/dealer, but mutual funds are a common way to invest in general obligation bonds and other municipal bonds.
General obligation bonds don't have collateral; instead, they are backed by the full faith and credit of the issuer. The municipality repays you from its collection of property taxes, sales taxes, tolls, property sales, license fees and other revenues (or other debt). Theoretically, the municipality has unlimited taxing power and thus should never default on the bonds. But because it can't print currency (like the U.S. Treasury does), bankruptcy is a real possibility.
For those who want a little more diversification, municipal bond investment trusts (MITs) are another way to invest in a basket of municipal bonds. The Municipal Securities Rulemaking Board (MSRB), which the SEC oversees, regulates general obligation bond underwriters and dealers.
2. Revenue Bonds
Revenue bonds are municipal bonds that fund specific projects that generate revenue. Toll roads are great examples -- the tolls from the toll road fund the interest and principal payments. If the toll revenue is insufficient, however, the issuer might not be able to make the payments.
Revenue bonds usually have $1,000 or $5,000 face values and pay interest semiannually, although some are zero-coupon bonds. Typical maturities are one to 30 years. If you own one, you usually don't have a claim to the project's assets (i.e. you can't repossess the toll road if the payments are late).
Revenue bonds may also have catastrophe call provisions, which allow the issuer to call the bonds if the revenue-producing facility is destroyed. For all these reasons, revenue bonds typically yield more than general obligation bonds because they carry added risks.
3. Public-Purpose Bonds
If you've ever gotten into a heated argument in a bar about whether the Raiders or the Chargers should move to L.A. and what a jerk the mayor is for wanting to/not wanting to pay for a new stadium, then congratulations, you're honing your debate skills about public-purpose bonds.
A public-purpose bond is a municipal bond that funds projects that benefit the general public rather than private groups or individuals. Determining what "benefits the general public" is controversial, but the rules of thumb often fall around whether private entities receive more than 10% of the proceeds and whether the project has broad social value.
The Tax Reform Act of 1986 created distinctions between public-purpose and private-purpose bonds in an effort to limit the tremendous temptation municipalities face to act as banks for private entities with projects that lack substantial social benefit.
The act, which made private-purpose bonds taxable, quelled much of this temptation. Today, there are many kinds of public-purpose bonds (i.e., general obligation bonds, revenue bonds), but overall, these bonds fund projects such as roads, libraries and infrastructure rather than football stadiums.
So as we've learned tax-free municipal bonds can be a great way to collect steady returns and preserve principal while skipping a tax bill. But one last caution to keep in mind: Tax legislation or even rumors about tax legislation can dramatically affect the value of munis.
And as with all bonds, muni prices rise when interest rates fall, and fall when interest rates rise. So be prepared and talk to your financial advisor about the risks involved before you dive into these tax-free investments.