Chapter 3 Study Notes Flashcards
Diversifying Holdings Geography
Geographical concerns are important since residents of a state may not be subject to state or local taxation if they purchase their state’s bonds. On the other hand, if they purchase out-of-state bonds, they are likely subject to state and/or local taxation
Diversifying Holdings Timing
Since there are such a wide variety of municipal bonds available on the market, it’s possible to purchase municipals to suit specific timing needs. For example, the purchase of zero-coupon bonds is an excellent way to save for a college education since all of the tax-exempt interest is paid at maturity. If future cash needs are uncertain, purchasing municipal bonds with different maturities will allow for additional flexibility.
Diversifying Holdings Maturity
Along with the issuer, the length of time to maturity is also an important factor when making an investment decision to purchase bonds. The longer a bond’s maturity, the longer the investor is exposed to interest-rate risk
Diversifying Holdings The Issuer
An issuer’s credit worthiness can decline after the purchase is made which results sin an increase in the credit risk. This increases an investor’s capital risk, which is the risk that an investor will lose his principal due to a default. Also, both inflationary risk and interest-rate risk are inherent in all fixed income securities regardless of the issuer’s creditworthiness.
Specific Issue
The decision regarding the specific issue to purchase can reduce and, in some cases, eliminate call risk. If the specific issue is non-callable, call risk is eliminated. An issue that can be called after 10 years will present less call risk than a bond that can be called after five years. Reinvestment risk can also be reduced or eliminated by a specific issue. The risk of being able to reinvest interest payments at the same rate as the yield-to-maturity is reduced as the amount of the interest payment is reduced. Reinvestment risk is eliminated altogether if interest payments are eliminated. A zero-coupon bond eliminates reinvestment risk because no interest payments are received by the investor.
Interrelationship of Factors
In the process of reducing risk, an investor must keep in mind that the basic objective of investing in fixed-income securities is yield (both current yield and yield-to-maturity)
triple tax exempt.
For bonds that are issued by U.S. territories or possessions (e.g., the Commonwealth of Puerto Rico, Guam, and the U.S. Virgin Islands), it’s important to note that they interest they pay is exempt from federal, state, and local tax. For this reason, these securities are referred to as triple tax exempt.
Tax on Interest Income
Private Activity Bonds (PAB) or Alternative Minimum Tax (AMT) Bonds
Bonds receive this classification if 10% or more of the bond proceeds are being used to finance a project that will be used by a private entity and if 10% or more of the bond proceeds will be secured by property that’s used in the private entity’s business. The interest on a private activity bond is subject to the AMT; therefore, the bond’s interest may be taxed at the federal level if the holder is subject to the AMT. As a result, these bonds may trade with a higher yield.
If an investor isn’t subject to the AMT, the purchase of PABs will not trigger a federal tax liability. Considering their potential tax liability, these bonds offer a slightly higher yield than non-AMT bonds.
Bank Qualified Issues
Banks that invest in these bonds are permitted to deduct 80% of the interest cost paid to depositors on the funds being used to purchase the bonds. In addition, the interest income on the bonds is tax-free. Bank qualified issues cannot be private activity bonds. Issuers may designate bonds as being bank qualified if they reasonably anticipate that the amount of these obligations will not exceed $10,000,000 in one calendar year.
Taxable Equivalent Yield
Net Yield
Net Yield = Taxable Yield x (100% – Tax Bracket %)
original issue discount (OID)
The appreciation in value (the amount of discount) is treated differently than a municipal bond that’s purchased at a discount in the secondary market. The discount on an OID must be accreted. In other words, each year, a portion of the discount is treated as interest for tax purposes and is added to the bondholder’s cost basis.
Since the accreted amount is treated as interest on a municipal bond, it’s tax exempt.
constant yield method or the constant interest method.
The first period’s (six months) accretion is determined by multiplying the offering price by one half the yield-to-maturity and then subtracting the actual amount of interest received
The calculated amount, which is the compound accreted value, is then added to the bondholder’s cost basis. Each successive period’s accretion is calculated in the same manner, but using the accreted cost basis in place of the original offering price
A zero-coupon bond is considered an OID and the discount is treated in the same manner as described above.
Taxation OID
De Minimis Exemption
For an original issue discount (OID) bond, if the amount of the discount is considered small (de minimis), it can be ignored. The IRS considers a discount to be de minimis if it’s less than one-fourth of 1% (1/4% or .25%) of the principal amount multiplied by the number of full years until the bond’s maturity.
