Market Beat: Who doesn’t like tax-free income?
Municipal bonds provide investors with tax-free income and historically are the safest type of bond behind only those issued by the United States government.
Basically, there are two types of municipal bonds, general obligation bonds and revenue bonds.
General obligation or GO bonds are backed by the full faith and credit of the issuing entity. A GO bond issued by the state of California is backed by the state’s tax resources.
Revenue bonds are backed by the revenue of an income producing enterprise, like toll roads, airports, water and sewer systems and other income producing activities. Revenue bonds typically have higher yields than general obligation bonds. They are normally analyzed in terms of the earnings potential of the project.
One way to determine if tax free bonds may be suitable for you is to calculate their taxable equivalent yield or TEY. Currently, a City of San Francisco GO bond that matures in 2039 has a yield to maturity or YTM of 3.157%. This particular bond is callable, so the City of San Francisco can buy it back from you at any time if it is to their benefit, like if interest rates go down.
For example, say your federal and state combined income tax bracket was 30%. To determine the TEY you’d divide the YTM by your tax bracket and get a yield of 4.5%. In other words, you’d need to find a taxable bond with a similar credit rating that has a 4.5% YTM to get the same after-tax income.
For comparison, presently a U.S. Treasury bond with a 20-year maturity only has a YTM of 1.87%. The 4.5% TEY from the San Francisco GO bond is more than double the yield of the U.S. Treasury bond.
California residents need to buy California issued bonds to be free of both federal and state taxation. If a California resident were to buy a municipal bond issued by another state, it would be free from federal tax, but not state income tax. You could still calculate your TEY by using just your federal income tax rate.
Investors in income tax free states, like our neighbors in Nevada can shop for bonds all over the country because state income tax is not a factor. Some states have provisions that if a school district bond issuer defaults, the bond then becomes a general obligation of the state that is was issued in.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.