Chapter 15 Tax Treatment of Municipal Bonds Flashcards
Corporate Equivalent Yield
Example: If an investor is in 28% federal tax bracket, what interest rate would they have to receive on a corporate bond to have the same after tax income as on a municipal bond yielding 6%?
Municipal Yield / (100% -investor’s Tax Rate) = Taxable Equivalent Yield
MC Hammer
6% / 100%-28%. = .06 / .72 = 8.33% corporate yield
The investor would have to buy a corporate bond yielding 8.33% to be equal of the 6% municipal bond yield.
Current Yield
Annual Interest / Market Price
Municipal Bond Premiums- premiums must be amortized
over the life of the bond, results in an amortized(reduced) cost basis for tax purposes. Accounting process determines the annual adjustment called “straight line method”
Example: In a Corporate Bond, if you bought it at a premium, lets say $1,200, and held to maturity( 10 years), you would receive $1,000 par, back at maturity, incurring a $200 loss for taxes.
But with Municipal Bond, you would have to write off $20 per year x 10= $200, or $20 annually.
If you sell the Municipal Bond EARLY, lets say in 5 years, you have written off $100( $20 per year x 5= $100). So now you NEW cost basis is $1,100 and NOT $1,200
Note: premiums on corporate bonds may either be amortized over the life of the bond or taken as a loss in full at maturity.
Original Issue Discount(OID)-
treat the discount as interest income and not as capital gain, favorable as interest income is tax exempted.
Secondary Market Discount
when the bonds are bought at a discount in the secondary market, the discount generally be treated as Ordinary Income which is fully taxable to the investor in the year the bond is sold.
Municipal Bonds trading at a discount are more volatile because they are more sensitive to interest rate changes than bonds trading at a premium.
Swaps
Reason to Swap a bond
- Upgrade a portfolio by switching into a higher rated bond
- Extend or shorten time to maturity
- Increase income or yield
- Realize capital losses for tax purposes
NOTE: Accrued interest would not be a reason to do a municipal bond Swap.
High Bracket individuals, commercial banks, and insurance companies are large buyers of municipal bonds due to the tax exempt status of the bond interest.
Charitable institutions, IRA’s and pension funds DO NOT benefit from the tax exempt status of municipal bonds since the companies are tax-free or tax deferred.
The Market for Municipal Bonds
Blue List- listing of Municipal bonds for sale by dealers( NO LONGER EXIST)
Does not contain quality of rating.
Inventory and listing of Municipal Bonds available in the secondary Market can also be found in the BOND TRAC and BOND EXPRESS.
The Bond Buyer- a daily newspaper giving the news and happening in the municipal market. Gives info about new issues.
30 day visible supply
measures the total number of new issues coming to market in the next 30 days. A good indicator of the expected supply in the new issue market for municipals. Broken down into two numbers:
Issues of General Obligation to be sold on
competitive basis
Issues of Revenue bonds to be sold on
negotiated basis
Bond Buyer Index
index that is made up of 20 General Obligation bonds each with 20-year maturities. A good indicator of the yield that buyers would receive if they purchased a similar bond.
Bond Buyers Revenue Bond Index
the average yield of 25 specific revenue bonds each with 30 year maturities.
The Municipal Bond Primary Market
When a new issue of municipal bonds will be offered to the public, the municipality will hire a broker dealer to handle the distribution.
The managing underwriter is the firm that serves as head of the syndicate group and determines the scale on a serial bond or the pricing on a term bond issue.
Earning Coverage or Debt Service Coverage
reelects the number of times by which the revenues for a period exceed the debt service payable in that period. Bond debt service found by dividing the municipality’s revenues by the annual interest and principal payments( debt service)
Earning coverage is the net revenue divided by debt service .
For Example: If a municipality has a revenue of 8,000,000 and 2,000,000 of interest and principal to be repaid that year, the coverage would be
8,000,000 = 4
2,000,000 1
The lower the debt service coverage, the lower the price of the bond and the higher the yield due to increased risk related to the payment of interest and principal on the issue.
Settlement Date for municipals bonds
Regular Way- 2nd business day
Cash Trade- same day
When, as and if issued. Settle on a date agreed upon by both parties.
Settled between firms with “Clearing House Funds”
If not regular way, settlement date would be agreed between the buyer and seller.