Interest on Municipal debt is normally exempt from federal tax. Because of this, they normally issue bonds with below market coupon rates. To fully judge the yield value of a municipal investment, you should examine the tax free yield that it offers.

A 5.5% Municipal Bond offered at par for an investor in the 28% bracket will offer that investor a better overall yield than the 5.5% coupon rate. The formula breaks down as follows:

5.5 coupon rate divided by 100 minus the tax bracket will give the investor their current tax free municipal bond yield.

5.5 divided by 72 (100-28) = 7.64%. This is what the municipal bond is equal to in a taxable investment to this investor or known as the Tax equivalent yield. If the person was looking for a corporate bond or other taxable investment, he would need an equivalent yield equal or better than 7.6% in that other investment to beat the municipal bond yield.

Municipal securities are more attractive to investors in higher tax brackets. If we place another investor into the above equation with a lower tax bracket, the yield will not be as strong.

Using a 20% tax rate:

5.5% divided by 80 (100-20) = 6.89%

Investors who purchase Municipals issued within their own state are usually exempt from state and local tax as well. This is known as being triple tax free. Munis purchased from U.S Territories (Puerto Rico, Virgin Islands, etc.) also qualify for triple tax free status.

Municipals are not exempt from capital gains tax. If a person sells a muni bond at a profit above their cost, the profit is fully taxable as a capital gain. This applies to Corporate bond issues as well.

Municipal Bond Rates:

Rates or coupons tend to trade lower than treasuries, given the tax free status of them. As you can see from the above examples, the tax exempt yields trade significantly higher.

Types

General Obligation (GO Bonds) bonds or notes are backed by the taxing power of the municipality. A school project is a good example of a bond issue being backed by taxes. The homes and property areas will be assessed a property tax increase to help bay for the bond issue.

Revenue Bonds are backed by an issuers ability to generate revenue to fund the issue. Bridges and tolls are the best examples of this type of underwriting. Revenue bonds are "generally" not rated as high as G.O. Bonds, simply because taxes are a more definitive source for an issuer. Revenue bonds rely on constant revenue to collect money required to meet debt service (bond interest and principle payments.

Both of these bond types offer the same tax free yeild advantages, although GO bonds tend to be at a greater credit quality because of the tax backing guarantee.

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