What is a Private-Purpose Bond?
A private-purpose bond is a fund private activities or benefit private parties.that uses a significant amount of its proceeds to
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 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 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 .
Investors who buy the ABC Town may be in for a surprise, however, because the is a private-purpose bond rather than a public-purpose ; 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 . Thus, the interest on the ABC Town 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 , quelled much of this temptation.
Why Does a Private-Purpose Bond Matter?
Municipalities often issue private-purpose bonds because they believe the it funds will stimulate the local . This is often the case for industrial-development , 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 .
Although one of the largest advantages of investing in is that the interest is usually exempt from federal (and most state and local if the investor lives in the state or municipality issuing the debt), this exemption only applies to public-purpose . Thus, every investor must read his bonds' 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 is taxable or tax-exempt according to the Tax Reform Act of 1986 and other related laws. 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.