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Answer:
Municipal
Bonds 101
Last
week, we partly answered a BuyandHolder's questions
about municipal bonds. (Click HERE
to read.) We didn't have space to tell you everything
you ever wanted to know about them, including the
various types, so here is Part 2.
Types
of Municipal Bonds
If
you decide to add munis to your portfolio, you have
a number of choices.
(1)
General Obligations Bonds (GOs)
Also
known as public purpose bonds, these are sold to finance
roads, schools and government buildings. The majority
of these bonds are voter approved. They are the most
conservative of the municipals and are backed by the
full taxing power of the state or local government
that issues them.
The
interest and principal are repaid to bondholders out
of a government's general revenue -- its taxes primarily.
Therefore, they generally have the highest safety
ratings.
(2)
Revenue Bonds
These
are issued to finance public works projects. Their
interest and principal are repaid only from the revenues
generated by the project that the bonds were issued
to build. For example, this could be an airport, highway,
tunnel, toll bridge or sewage treatment plant. Because
of this somewhat limited source of income, revenue
bonds are generally regarded as less safe than GOs.
(3)
Taxable Municipals
For
many years, all munis were tax free, but that's no
longer the case. Bonds issued to finance private business
activities and ventures, such as shopping malls, sports
stadiums, industrial parks and parking facilities,
are often exempt from state and local taxes where
issued, but are subject to federal income taxes. They
are often referred to as "activity bonds."
Just
to add to the confusion -- income from certain kinds
of private activity bonds, such as those to build
a hospital, is still fully exempt.
These
taxable municipals generally yield 2% to 3% more than
fully tax-exempt municipals.
(4)
Zero Coupon Municipals
These
bonds provide no interest income to the owner until
they mature. Instead, they are sold at a discount
(called below par) and you receive the full face value
at maturity. Because they are sold far below face
value, zero coupon munis are an inexpensive way for
small investors to participate in the municipal bond
market.
Stripped
munis, as one part of this investment is called,
literally have their semiannual interest rate coupons
stripped off. Both parts are then sold separately
-- the principal and the series of coupon interest
payments.
Prior
to the creation of stripped munis, bondholders were
forced to wait 20 to 40 years for a municipal bond
to mature. Zeros, on the other hand, mature in less
than half that time.
Zero
Coupon Convertible Municipals
Like
other zeros, these bonds sell at a deep discount to
their face value. They come with a unique feature:
at a certain date they actually convert into regular
interest bonds.
For
example, a 25-year zero coupon convertible muni bond
might pay no interest during its first 10 years. Then,
in the 10th year, it converts into a regular municipal
bond. At that point, the investor starts to receive
the stated interest rate in cash and continues to
receive interest for the remaining 15 years.
At
maturity, the bond returns its full face value of
$1,000 to the investor.
Both
appreciation and interest income are free of federal
income taxes.
Pre-refunded
or Escrowed-to-maturity Bonds
Sometimes
a municipality floats a new bond issue when interest
rates have dropped, in order to pay off the first
bond. The proceeds from the sale of the second bond
are invested in U.S. Treasury securities. These securities
are held in escrow until the old bonds can be redeemed
-- at their call date in the case of pre-refunded
bonds, or at their maturity date in the case of escrowed-to-maturity
bonds.
Because
the money to repay the bondholders is set aside and
safely invested in Treasuries, these bonds are considered
very safe.
Variable
Rate Option Municipals
These
are long-term municipals whose interest rates are
adjusted up or down each year, based on current market
rates. You can usually cash in a variable-rate option
muni on a daily, weekly, monthly or yearly basis and
get back what you paid for it. They are best if you
know you might need your money within a year, or at
least before the bond matures.
Single
State Municipals
If
you live in a high-tax state, you should look for
munis issued by your own state and, if possible, by
your local government. By avoiding state and local
taxes you can improve your after-tax return, often
adding as much as 1 1/2% to your yield.
A
Word About Safety...
Like
corporate bonds, municipals are also rated for safety
-- that means how likely they are to default. The
safest are rated triple A. Keep in mind, that the
higher the rating, the less interest the bond issuer
needs to pay to attract investors. The opposite is
also true -- the highest interest rates are paid on
the riskiest bonds.
You
may come upon bonds that are not rated. An unrated
bond is not necessarily high in risk. It may be unrated
because the municipality is so small or has such modest
debt that its bonds have never been rated. However,
unless you personally know something about the community,
stick with high rated bonds.
Bottom
Line: If we haven't covered something you want
to know about munis, simply write in and we'll discuss
it in a future column.
A
Little-Known Tip...
Bonds
issued by the Commonwealth of Puerto Rico come with
a great plus -- their income is free from local, state
and federal taxes no matter where you live in the
United States! And, to date, Puerto Rico has never
defaulted on a bond issue.
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