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Taxable and Tax-Free Bonds

Danielle Nava

Tax-exempt bonds

Unlike corporate bonds, some bonds offer investors a tax exemption that depends on who issues the bond. In general, tax-exempt bonds fall into two categories: securities issued by the U.S. Treasury and municipal bonds (or munis), which are issued by state and local governments. The income from Treasury securities is exempt from state and local taxes but not from federal taxes. However, when investors refer to tax-exempt bonds, they are often referring to municipal bonds which are generally exempt from federal income tax (though specific issues may be taxable). Munis also may be exempt from state and local taxes for investors who live in the state in which the bond is issued, though regulations vary from state to state.

Caution: Although most states exempt from state taxes municipal bonds issued within the state while taxing munis from other states, not all do so. Some tax both in-state and out-of-state munis, and some tax neither. Consult a local tax professional before investing to make sure of your state’s tax policy.

Because of their favorable tax treatment (and in the case of Treasury securities, their relative safety), tax-exempt bonds typically yield less than a corporate debt instrument with an identical maturity period. They have traditionally been most attractive for investors in high tax brackets, because their favorable tax treatment can mean the return can be higher than that of bonds that pay taxable interest. A bond’s tax-exempt status applies only to the interest paid on the bond; gains from any increases in the bond’s value are taxable.

Technical Note: So-called Build America Bonds (BABs), authorized by the American Recovery and Reinvestment Act of 2009 for issuance through December 31, 2010, are taxable municipal bonds whose interest payments are partly subsidized by the federal government. Those subsidies represent 35 percent of the total coupon interest owed by the bond’s issuer, though the amount of those subsidies may be subject to federal funding cutbacks. Depending on the bond, the subsidy may be in the form of a refundable tax credit paid to the governmental issuer (a Direct Payment BAB), or a federal tax credit for the bondholder (a Tax Credit BAB).

Caution: Not all munis enjoy a tax advantage; a bond’s status depends on what the municipality or state is using the bond proceeds to fund. For example, taxable munis might fund local sports facilities, investor-led housing developments, and certain municipal refinancing strategies that the federal government deems not to provide a significant benefit to the public at large. Private activity bonds (also known as nonessential function bonds or private purpose bonds) are those in which 10 percent or more of the bond’s benefit goes to private activities, or 5 percent of the proceeds (or $5 million if less) are used for loans to parties other than government units. Generally, private activity bonds are taxable unless their use is specifically exempted from taxation.For example, the American Recovery and Reinvestment Act of 2009 specifically exempts interest on private activity bonds issued in 2009 and 2010 from being included in calculations of the alternative minimum tax (most private activity bonds are considered an item of tax preference and are therefore included when calculating AMT liability.)

There are several types of municipal bonds. General obligation bonds are backed by the issuer’s taxing power; revenue bonds are backed by revenues from the project being funded. Other types include industrial development bonds and baccalaureate or college-saver bonds.

Refunded and pre-refunded municipal bonds

Bond issuers sometimes choose to issue new bonds to pay off the obligations of older bonds, in somewhat the same way a homeowner might refinance a home mortgage in a time of falling interest rates. The proceeds of the new bond or bonds can be used to replace a specific revenue source that was pledged to repay the interest and principal of older bonds (for example, a tax collected by the issuer or the revenues of a bond-funded project).

The money obtained from issuing the newer bond is generally put into escrow and paid out over time as the older bond’s obligations come due. Because the older bond no longer relies on its original funding source but on the escrowed proceeds, the older bond is then considered a refunded bond.

Bonds that are refunded through their maturity dates are said to be “escrowed to maturity.” The escrowed money is typically invested in or collateralized by U.S. Treasury securities that are scheduled to mature as the refunded bond’s interest and principal payments are due. If a refunded bond’s original documents include a call provision that allows the issuer to pay off the bond before its maturity date, the bond is referred to as a pre-refunded bond. Because refunding typically occurs after interest rates have fallen, refunded bonds generally offer a higher coupon rate than newer issues with the same quality and maturity. As a result, refunded bonds often will sell at a premium to their par value. Also, because they are backed by escrowed money that is typically invested in or collateralized by U.S. Treasury securities, they are generally considered to be of similar high quality as Treasuries.

Caution: A refunded bond itself is not backed by the full faith and credit of the U.S. Treasury. Also, municipal bonds are subject to the risks associated with any fixed income security, including interest rate risk, credit risk, and reinvestment risk.

Taxable bonds

The interest on corporate bonds is taxable at ordinary income tax rates by local, state, and federal governments. Issuers of taxable bonds typically must pay a higher interest rate than issuers of tax-exempt bonds in order to attract investors.

Agencies and government-sponsored enterprises (GSEs) vary in their tax status. Interest from Ginnie Maes, Fannie Maes, and Freddie Macs is fully taxable at federal, state, and local levels. The bonds of other GSEs, such as the Federal Farm Credit Banks, Federal Home Loan Banks and the Resolution Funding Corp. (REFCO), are subject to federal tax but exempt from state and local taxes. Before buying an agency bond, you should verify the issuer’s tax status.

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