MUNI BOND BASICS FLASHCARDS
From VMSXX p045 vanguard prospectus
Define are Muncipal Bonds?
- A typle of bond. 2. An interest-bearing security issued by state governments, local governments, government authorities.
List the two kinds of property that Municipal Bonds finance
- Pay for geovernment services; 2. Build public works projects.
What two payments do issuers of Municipal bonds pay holders of these bonds?
- Periodic interest payments; 2. Repay the principal amount of the bond at its stated maturity.
What’s the unique tax characteristics of Municipal Bonds?
- Periodic interest payments to bondholders are tax-free from Federal Income Tax. 2. [Are long term capital gains from principal recovery on sale also tax-free? I don’t know]. 3. Periodic interest payments to certains bond-holders maybe taxed at ALTERNATIVE MINIMUM Tax Rates.
When does it make sense to invest in a Municipal Bond?
When the bond’s “taxable-equivalent yield “is higher than a regular bond’s taxable yield.
State the Taxable-equivalent Yield Formula
Tax Exempt Munibond Yield % divided by: [100% less (Shareholder’s Marginal Tax Rate % plus the Medicare Tax Rate 3.8%)]
Assume Tax-Exempt Muni Bond Yield = 5%. Tax payer Marginal Federal Tax Bracket = 37%. Medicare Tax add-on rate %. Taxable Bond Yield = 7%. Calculate Muni Bond Tax Equivalent Yield.
5% divided by [100% less 37% less 3.8%] = 8.45% Tax Equivalent Yield
Define “Interest-Rate Risk”
The negative effects on exisiting bond yields from an increase in interest rates.
What direction on existing Long-term bond prices does an increase in interest rates pose?
Increasing interest rates force exisiting bond prices (i.e. bonds trading in the market to decrease.)
What direction on existing short-term bond prices does an increase in interest rates pose?
Not much decline. Because of short-term bond’s short maturity.
List some market factors that can cause interest Rates to rise and fall.
- Central Bank monetary policy; 2. Inflation; 3. Deflation; 4. War; 5. Stockmarket panic; 6. Economic indicators: unemployment, GDP growth; Soverign debt; Wage Stagnation; Production supplychain disruptions.
What direction on existing long-term bond prices does an increase in interest rates pose?
A large negative downward adjustment in prices.
Take image of VMSXX page 40 table showing increase/decrease of 1% of interest rates. Sowing increase/decrease of 2% of interest rates.
take photo of table from.
Why do bond prices fall when interest rates rise?
A 4% bond would have to lower its price inorder to keep it competitive yield in line with a new 5% bond yield arriving in the market.
Does a bond’s Income always fall when interest rates rise?
Not if the bond is trading in the secondary bond market at the time of the drop in interest rates. The original “ Coupon Rate” on the bond when originally assured, (remains unchanged thoughout to maturity.)
Does a newly issued bond’s Income always equal the interest rate rise at the time the new bond was issued?
Yes.
Define a “Call Feature” advantageous for the bond holder?
When the bond’s issuer has a right to redeem the bond earlier than the bond’s maturity date.
Is a bond’s “call Feature” advantageous for the bond holder?
Usually not. Call features commonly are exercised when interest rates fall and the issuer can reissue the bond at a lower interest rate cost. Bond holders are forced into explacing the bond at a lower “coupon” rate (i.e income) to reflect the new less desirable interest rate environment.
How do bond investors react to protect themselves against “bond call risk”?
Buy the callable bond when its stated “call dates” is far into the future. Purchase dates with short run-ups to a bond call date leave you vulnerable to issuer exercising bond’s call feature.
How do bond investors react in order to protect against “bond call risk”?
Purchase lower coupon rate bonds (i.e. short term bonds). Makes them less likely to be called when matruity is not too far in future.
Define “Extension Risk” in bonds
During periods of rising interest rates, issuers retiring low coupon bonds may pay delay retiring these bonds as replacing them entails greater interest expense. This stunt can result in falling bond prices as questions about issurer’s ability to pay future interest and/or principal lowers the subject bond’s credit quality.
Define “Credit Risk” in bonds
The potential negative effect on a bond price from an issuer who may experience a problem meeting periodic interest payments. Or also applied to principal payments. Ther perception of a struggling bond issuer will trigger price reducitons of that bond’s market price.
When is bond “Credit risk” the lowest?
When the bond’s issuer is rated high. When the market perceptions of the issuer ever missing a bond payment over the life of the bond issue are nil.
How do you control for “credit risk”? (i.e. you want to minimize credit risk at all cost!)
You purchase bonds that are considered “high quality” when you want low credit risk (aka: low interest income and low probability of default)). You also consider buying a bond that has only a and/or short term yet to go before it reaches maturity.
Define the bond term “Credit Quality”
An assessment of the issuer’s ability to pay interest on the bond and repay principal. Low credit quality infers perception that issuer has greater than minimum risk of default. For investros to purcahse low credit quality requires a high yield on investment.
Define “Liquidity Risk” for bonds
The chance that a bond holder may not be able to sell the bond in a timely manner at a desired price.
How does US Tax Code view bond income from “Tax Preference Items”?
Applies a special tax on bond “tax preference item” income. Called Alternative Minimum Tax (AMT). AMT tax take the place of Federal Iincome tax applied to bond “tax preference item” income.
