Municipal Bonds Revisited

With the Presidential Elections drawing to a close and one side advocating an income tax increase, it might be a good idea 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 of interest.

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 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 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. This will 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.

Keith W. Springer, President of Capital Financial Advisory Services is a Registered Investment Advisor and a Mortgage Broker here in Natomas, located on the river at 1383 Garden Hwy. You can contact him at 916-925-8900 or keith@capfas.com