What is a Private-Purpose Bond?
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 Does a Private-Purpose Bond Work?
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 Does a Private-Purpose Bond Matter?
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.