Municipal Bonds

Municipal bonds are issued by state and local governments. They are similar to Treasury and corporate bonds except that their interest income is exempt from federal income taxation. The interest income also is exempt from state and local taxation in the issuing state. Capital gains taxes, however, must be paid on "munis" when the bonds mature or if they are sold for more than the investor's purchase price.

There are basically two types of municipal bonds. These are general obligation bonds, which are backed by the "full faith and credit'' (i.e., the taxing power) of the issuer, and revenue bonds, which are issued to finance particular projects and are backed either by the revenues from that project or by the particular municipal agency operating the project. Typical issuers of revenue bonds are airports, hospitals, and turnpike or port authorities. Obviously, revenue bonds are riskier in terms of default than general obligation bonds.

An industrial development bond is a revenue bond that is issued to finance commercial enterprises, such as the construction of a factory that can be operated by a private firm. In effect, these private-purpose bonds give the firm access to the municipality's ability to borrow at tax-exempt rates.

Like Treasury bonds, municipal bonds vary widely in maturity. A good deal of the debt issued is in the form of short-term tax anticipation notes, which raise funds to pay for expenses before actual collection of taxes. Other municipal debt is long term and used to fund large capital investments. Maturities range up to 30 years.

The key feature of municipal bonds is their tax-exempt status. Because investors pay neither federal nor state taxes on the interest proceeds, they are willing to accept lower yields on these securities. These lower yields represent a huge savings to state and local governments. Correspondingly, they constitute a huge drain of potential tax revenue from the federal government, and the government has shown some dismay over the explosive increase in use of industrial development bonds.

By the mid-1980s, Congress became concerned that these bonds were being used to take advantage of the tax-exempt feature of municipal bonds rather than as a source of funds for publicly desirable investments. The Tax Reform Act of 1986 placed new restrictions on the issuance of tax-exempt bonds. Since 1988, each state is allowed to issue mortgage revenue and private-purpose tax-exempt bonds only up to a limit of $50 per capita or $150 million, whichever is larger. In fact, the outstanding amount of industrial revenue bonds stopped growing after 1986, as evidenced in Figure 2.6.

An investor choosing between taxable and tax-exempt bonds must compare after-tax returns on each bond. An exact comparison requires a computation of after-tax rates of return that explicitly accounts for taxes on income and realized capital gains. In practice, there is a simpler rule of thumb. If we let t denote the investor's marginal tax bracket and r denote the total before-tax rate of return available on taxable bonds, then r(1— t) is the after-tax rate available on those securities. If this value exceeds the rate on municipal bonds, rm, the investor does better holding the taxable bonds. Otherwise, the tax-exempt municipals provide higher after-tax returns.

One way to compare bonds is to determine the interest rate on taxable bonds that would be necessary to provide an after-tax return equal to that of municipals. To derive this value, we set after-tax yields equal, and solve for the equivalent taxable yield of the tax-exempt bond. This is the rate a taxable bond must offer to match the after-tax yield on the tax-free municipal.

CHAPTER 2 Markets and Instruments 39

Figure 2.6 Outstanding tax-exempt debt.

1400

1200

1000

m

0

1

2

CO

4

LO

6

8

CD

0

1

2

CO

4

m

6

8

CD

0

8

8

8

8

8

8

8

8

8

8

Ol

Ol

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Ol

CD

CD

CD

0

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Ol

Ol

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CD

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Ol

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CD

CD

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0

1

1

1

1

1

1

1

1

1

1

1

1

1

1

1

1

1

1

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1

1

2

■ General obligation □ Industrial revenue bonds

t y y Y Y I

Source: Flow of Funds Accounts: Flows and Outstandings, Washington, D.C.: Board of Governors of the Federal Reserve System, second quarter, 2000.

Table 2.2 Equivalent Taxable Yields Corresponding to Various Tax-Exempt Yields

Marginal Tax Rate

Tax-Exempt Yield

2%

4%

6%

8%

10%

20%

2.5

5.0

7.5

10.0

12.5

30

2.9

5.7

8.6

11.4

14.3

40

3.3

6.7

10.0

13.3

16.7

50

4.0

8.0

12.0

16.0

20.0

Thus the equivalent taxable yield is simply the tax-free rate divided by 1 - t. Table 2.2 presents equivalent taxable yields for several municipal yields and tax rates.

This table frequently appears in the marketing literature for tax-exempt mutual bond funds because it demonstrates to high-tax-bracket investors that municipal bonds offer highly attractive equivalent taxable yields. Each entry is calculated from equation 2.5. If the equivalent taxable yield exceeds the actual yields offered on taxable bonds, the investor is better off after taxes holding municipal bonds. Notice that the equivalent taxable interest rate increases with the investor's tax bracket; the higher the bracket, the more valuable the tax-exempt feature of municipals. Thus high-tax-bracket investors tend to hold municipals.

Figure 2.7 Ratio of yields on tax-exempt to taxable bonds.

0.95

0.95

0.50 +1955

1960 1965 1970 1975 1980 1985 1990 1995 2000

0.50 +1955

1960 1965 1970 1975 1980 1985 1990 1995 2000

Source: Data from Moody's Investors Service.

CONCEPT CHECK ^ QUESTION 3

We also can use equation 2.4 or 2.5 to find the tax bracket at which investors are indifferent between taxable and tax-exempt bonds. The cutoff tax bracket is given by solving equation 2.4 for the tax bracket at which after-tax yields are equal. Doing so, we find that r

Thus the yield ratio rm/r is a key determinant of the attractiveness of municipal bonds. The higher the yield ratio, the lower the cutoff tax bracket, and the more individuals will prefer to hold municipal debt. Figure 2.7 graphs the yield ratio since 1955. In recent years, the ratio has hovered between .75 and .80, implying that investors in (federal plus local) tax brackets greater than 20% to 25% would derive greater after-tax yields from municipals. Note, however, that it is difficult to control precisely for differences in the risks of these bonds, so the cutoff tax bracket must be taken as approximate.

Suppose your tax bracket is 28%. Would you prefer to earn a 6% taxable return or a 4% tax-free return? What is the equivalent taxable yield of the 4% tax-free yield?

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