A tax-exempt bond is a type of bond whose interest payments are not subject to federal income tax. This characteristic makes them particularly attractive to investors in higher tax brackets seeking tax-efficient income. Tax-exempt bonds are commonly issued by government entities such as municipalities, states, and other local government authorities to fund public projects.
Types of Tax-Exempt Bonds
Municipal Bonds
Municipal bonds (or “munis”) are the most common type of tax-exempt bond. They are issued by local governments, municipalities, and state governments to finance public works and community infrastructure projects.
Revenue Bonds
Revenue bonds are municipal bonds supported by the revenue generated from specific projects or sources. These can include utilities, toll bridges, and other income-generating public enterprises.
General Obligation Bonds
General obligation bonds are supported by the issuing government’s taxing power. These bonds are typically considered safer than revenue bonds, as they are backed by the issuer’s full faith and credit.
Salient Features
Tax Benefits
One of the primary benefits of tax-exempt bonds is that their interest payments are free from federal income tax. This can significantly increase the bond’s effective yield for investors in higher tax brackets.
Credit Quality
Tax-exempt bonds often carry high credit ratings due to the issuing body’s authority to levy taxes or generate revenue to repay the bond.
Lower Interest Rates
Since the interest income is tax-exempt, tax-exempt bonds tend to offer lower interest rates compared to taxable bonds. This trade-off is generally favorable for investors looking to minimize tax liability.
Historical Context
The concept of tax-exempt bonds emerged in the early 20th century in the United States as a way to lower the cost of borrowing for public projects. The tax-exemption on municipal bonds was codified in the Internal Revenue Code of 1913, aligning the federal tax policy with local and state infrastructure funding needs.
Applicability and Use Cases
Public Projects
Tax-exempt bonds are frequently issued to finance public infrastructure projects such as roads, schools, and hospitals.
Investment Portfolios
High-net-worth individuals and institutional investors often include tax-exempt bonds in their investment portfolios to take advantage of the tax benefits and lower risk associated with these securities.
Comparisons
Tax-Exempt Bonds vs. Taxable Bonds
- Tax-Exempt Bonds: Interest payments are not subject to federal income tax.
- Taxable Bonds: Interest payments are subject to federal income tax, often resulting in higher nominal interest rates to compensate for the tax liability.
Tax-Exempt Bonds vs. Corporate Bonds
- Tax-Exempt Bonds: Issued by government entities, usually lower risk and lower interest rates.
- Corporate Bonds: Issued by private corporations, typically higher risk and higher interest rates.
Related Terms
- Yield to Maturity (YTM): The total return anticipated on a bond if held until it matures, considering both interest payments and capital gains or losses.
- Taxable Equivalent Yield: The yield on a taxable bond required to equal the yield on a tax-exempt bond, used by investors to compare potential returns.
FAQs
Are tax-exempt bonds always free from state and local taxes?
Who should invest in tax-exempt bonds?
Do tax-exempt bonds have any risks?
References
- Internal Revenue Code (IRC) Section 103 - Legal foundation for tax exemption on municipal bond interest.
- Municipal Securities Rulemaking Board (MSRB) - Regulatory agency that creates rules for municipal security firms, banks, and brokers.
- “The Handbook of Municipal Bonds” by Sylvan G. Feldstein and Frank J. Fabozzi - A comprehensive guide to municipal bonds and tax-exempt investing.
Summary
A tax-exempt bond provides significant tax benefits by offering interest payments that are not subject to federal income tax. Commonly issued by municipal and state entities to fund public initiatives, these bonds are a valuable tool for both public financing and tax-efficient investing. With different types such as general obligation and revenue bonds, they offer varying degrees of risk and credit quality. Understanding the historical context, applicability, and related terms helps investors make informed decisions to maximize their portfolio’s tax efficiency and overall performance.
