Reconsider Tax-Free Municipals in Light of Potential Rising Tax Rates

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Municipal Bonds The recent debate over the millionaire’s tax or the so called “Buffett Rule” should have attracted the attention of upper income taxpayers. The federal government is looking for new sources of revenue. Raising the taxes on 1% of Americans is not going to erase massive government deficits.The President’s position has been that tax increases will only be experienced by taxpayers earning over $250,000. Lowering the income threshold to this level increases affected taxpayers to 5% of the population. Making a meaningful dent in the deficit may have to include incomes below the $250,000 level. This might be a good time to shake the dust off our tax-free investing books. If protecting your income from taxation is a priority, a new look at the tax-free, municipal bond market may be your cup of tea.

When state and local governments want to invest in bridges, highways and other capital improvements they finance the investment by issuing municipal bonds. These bonds pay interest that is exempt from federal income tax as well as the state income tax of the state where it was issued. This tax exemption results from the theory of reciprocal immunity: States do not tax federal government bond interest and the federal government does not tax interest of state and local government issues.

Municipal bonds generally come in two flavors: general obligation bonds that are paid from property and income tax revenues, and revenue bonds that are paid back by the revenue generated from the invested proceeds of the bond issue such as a municipal stadium or toll bridge.

Bonds are issued in units of $1,000, but since the mid-1970s the minimum bond denomination has been $5,000. “A bond” is bought, sold, referred to and priced as if it were $1,000. For pricing purposes the par value of “a bond” is considered to be expressed as to the $100.

Once bonds have been issued, the secondary market prices the bond issues on the basis of credit risk and the bond’s yield. Wall Street underwriters and commercial rating companies provide relative indications of bond creditworthiness. Rating agencies such as Standard & Poor’s, Moody’s Investors Services and Fitch use alpha ratings to grade bonds. Investment grade bonds are AAA (highest, most credit worthy), AA, A, and BBB for S&P and Fitch, while Moody’s uses Aaa, Aa, A and Baa for comparable rating. Anything further down the alphabet is considered less than investment grade.

Investors seeking more security and less risk can purchase bonds insured by private insurance companies that guarantee to pay principal and interest when due. Insuring the bond will sometimes provide a credit rating of triple-A and thus a lower borrowing cost for the issuer. It will also result in payment of a lower yield, or interest coupon, to the bondholder.

The current interest rate environment plays a role in bond pricing. The basic rule is that when interest rates fall, bond principal prices go up. The reverse is true when interest rates rise. The current yield of a bond is the ratio of the coupon rate on a bond to the dollar purchase price expressed as a percentage. Therefore, if bond par is $1,000, expressed as $100, and the yield coupon is 4%, the current yield is 4%. However as interest rates for comparable new issues fall, the market price may increase to $1020, expressed as $102, and the same 4% coupon represents a current yield of 3.92%.

Bonds may be issued with call features, allowing the issuer the right to call the bond at a stated price. Think of this in the same terms as you would when refinancing your home mortgage. Mortgage rates go down, you refinance for a lower rate. Callable bonds work the same way, with the issuer paying the holder back a principal sum and then refinancing the bonds at a lower rate or simply paying off the debt early.

Bonds are often quoted with a yield-to-maturity return that takes into account the interest rate, length of time to maturity and price paid. If quoted with a yield-to-call figure, pricing reflects the same data taking into consideration the call date, and any potential call premium offered by the issuer.

If current dividend taxation (maximum 15% Federal rate for qualified dividends) remains the law of the land, municipal bonds may not be as attractive. However if the dividend tax reduction is rolled back, and dividends are then taxed as ordinary income, the tax-free yields of municipal bonds will become more attractive to tax payers in higher tax brackets.

Municipal bond interest will be even more attractive when the new MedicareTax begins in 2014. The new tax applies to investment income but does not include municipal bond interest. The Buffett Rule would also make municipal bonds more attractive because thebond interest would not be subject to the tax. The tax as proposed is based on adjusted gross income (AGI). Municipal bond interest does not affect AGI which will be very valuable to the upper income investor. This could be a great time to hold municipal bonds even with interest rates at historic lows.

Rick’s Insights

  • Municipal bond interest can help reduce tax on other taxable income by lowering
    thresholds that push you into a higher tax bracket.
  • Increased demand for municipal bonds beginning in 2014 could help increase their
    value even if interest rates rise.

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