Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Tax-free municipal bonds

Dear Dr. Don,
Could you please explain what tax-free municipal bonds are?
Joann Justification

Dear Joann,
Municipal bonds are bonds issued by state and local government agencies. The federal government exempts the interest income from federal income taxes. The idea behind this is that since the money from the bond issue is going to fund infrastructure or needed government services, the federal government supports the state and local government by making the interest income free of federal taxation.

The tax-free status allows the issuing government agency to borrow money at a lower interest rate. Investors buy these tax-free issues because on a tax-equivalent basis the returns are at or above the interest rate they would earn on a comparable-risk taxable bond. You can use this tax-equivalent yield calculator to compare the yield on a municipal bond investment with the yield on a taxable bond investment.

The federal government encourages state and local governments to invest in public projects and services. The issuing agencies benefit by paying lower interest rates, and investors get tax-free interest income.

In most states, buying municipal bonds issued by government agencies in your home state will also exempt the interest income from state taxes. (Sometimes called double tax-free bonds) This gets municipal investors to invest in bonds issued by government agencies in their state of residence because the tax-equivalent yield is even higher.

Illinois, Iowa, Kansas, Oklahoma and Wisconsin have different standards than the rest of the states about what constitutes a state tax-free municipal bond.

In metropolitan areas where there is a local income tax, investing in municipal bonds issued by local government agencies will provide interest income that is exempt from income taxes on the federal, state and local levels. New York City municipal bonds are an example of municipal bonds where city residents can invest and pay no federal, state or local income taxes on the interest income. (Triple tax-free bonds)

There are many different types of municipal bonds. Two key types of municipal bonds are revenue bonds and general obligation bonds. Revenue bonds are bonds where the principal and interest payments are funded from project revenues. Construction of a city- or county-owned parking garage could be financed with a revenue bond, and the debt service would be paid from the parking fees collected.

General Obligation (G.O.) bonds are bonds backed by the full faith and taxing power of the issuing agency. A G.O. bond issued to fund the same parking garage would be considered to have less risk because the debt-service payments are tied to the tax base vs. the revenue stream from the parking fees. There are many variations on the types of municipal bonds issued by government agencies, but a key point in all issuances is: Does a revenue stream or the taxing authority of the issuing agency back the bonds?

Many issuing agencies now insure their bonds to guarantee the repayment of principal on an issue. Like all debt issues, the riskier the credit the higher the interest rate investors will require to invest in the bonds. From the issuer's perspective, buying insurance is less expensive than paying the higher interest rate. From the investor's perspective, having the insurance is worth the lower interest rate. When you buy an AAA insured municipal bond, the risk to you as an investor is minimal.

Municipal bonds have credit ratings just like corporate bonds. Riskier municipal issues pay higher interest rates because of the additional risk. If the parking garage is financed with a revenue bond and the projected revenue doesn't materialize, the bondholder is at risk. A revenue bond will typically have a reserve fund that will allow the issue to weather a short-term revenue shortfall.

Investors who are subject to federal or state alternative minimum taxes (AMT) need to be aware that interest income from municipal bonds classified as nonqualified private activity bonds may be subject to the AMT. If you expect to be subject to AMT, you shouldn't invest in nonqualified private activity bonds.

Your broker or tax adviser can provide you with additional information, or see IRS Publication 550, Investment Income and Expenses, for more about private activity bonds.

-- Posted: Feb. 1, 2002