As an old saying from the investment community goes: it's not what you earn - it's what you keep. This phrase is appropriate in regard to the yield on an investment after the investor pays income taxes. Investors in high income tax brackets can earn a better after-tax rate of return by investing in tax-exempt municipal bonds, which pay interest that is free from federal income taxes. There are a number of activities that can affect the price and yield of such tax-exempt bonds.
Tax-exempt municipal bonds are issued by agencies of state and local governments. Unlike debt instruments of the federal government, which are backed by the full faith and credit of the U.S. government, debt instruments of state and local agencies are typically affected by the credit rating of the issuing organization. Municipal bonds are rated by a credit agency such as Moody's or Standard & Poor's. This is based on the issuing agency's perceived ability to meet its interest obligations and repay the debt upon maturity. A lower credit rating usually results in a higher interest rate, while a higher credit rating usually translates into a lower interest rate.
Long-term debt instruments involve greater risk than short-term debt instruments. This is because of the uncertainty regarding financial factors such as prevailing interest rates, population shifts (which can affect the issuing municipality's tax base), and other economic variables. Tax-exempt municipal bonds with long-term maturities usually offer higher rates to compensate for the added risk of tying up money for an extended period of time.
Tax-exempt municipal bonds are usually issued with a $5,000 face value and a specified interest rate, which is either fixed or variable. These bonds are redeemed for their face value upon maturity, but the price the bonds may vary significantly in the secondary market. The price of a bond tends to move in the opposite direction of prevailing interest rates. This means that if the prevailing interest rate of new bonds with similar credit ratings and maturities increase, the price of the existing bond will likely decrease to remain competitive in the market. The price of a municipal bond can also rise or fall if the credit rating of the issuing organization is upgraded or downgraded by a major credit rating organization.
The interest on municipal bonds is usually, but not always, exempt from federal income taxes. The interest on municipal bonds can be exempt from state and local income taxes. States can offer tax exemption for certain municipal bonds that are issued by entities within the state, but tax the interest on bonds from other states. Any capital gains you receive for selling a tax-exempt bond at a premium are taxable at the federal, state and local levels.
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