Lesson 2.4: Municipal Bonds

Municipal bonds are often called tax-exempts. This refers to the exemption of their income from A)federal income taxes. B)state, federal, and inheritance taxes. C)federal estate taxes. D)state income taxes.

A)federal income taxes. Explanation Although municipal bonds are sometimes exempt from state income tax (if issued in the state of residence of the taxpayer), all references to tax exemption refer to their exemption from federal income taxes.

If a resident of New York City purchases an Albany, New York, general obligation bond that yields $600 of interest during the course of the year, how is the interest taxed? A)It is subject to federal income tax at ordinary rates. B)It is not subject to federal income tax. C)Taxation is deferred until the bond matures. D)It is subject to state income tax at ordinary rates.

B)It is not subject to federal income tax. Explanation Interest from municipal bonds is exempt from federal income tax. While municipal bond interest is usually taxed at the state level, most states have an internal rule that exempts interest on their state and local municipal bonds.

As defined in the Securities Exchange Act of 1934, the term municipal security would include A)a U.S. Treasury bill. B)50-year bonds issued by the Tennessee Valley Authority. C)a City of Chicago school district bond. D)a Province of Ontario library construction bond.

C)a City of Chicago school district bond. Explanation Under federal law, municipal bonds are those issued by any domestic political body or subdivision from the state level on down. Treasury bills and TVA issues are defined as government securities, not municipal securities. Under federal law, Canadian cities (or provinces) are not municipal securities.

As defined in the Securities Exchange Act of 1934, the term municipal security would include all of the following except A)a State of Texas general obligation bond. B)a New Jersey Turnpike revenue bond. C)a City of Atlanta, GA, public library bond. D)an Illinois Tool Company debt issue backed by its full faith and credit.

D)an Illinois Tool Company debt issue backed by its full faith and credit. Explanation The Illinois Tool Company is a corporation, even though it has a state in its name. Under federal law, municipal bonds are those issued by any domestic political body or subdivision from the state level on down.

Your client in the 35% federal income tax bracket currently owns some corporate bonds with a coupon yield of 7%. In order to receive the same income after taxes, he would need to buy municipal bonds with a coupon of A)4.55%. B)2.45%. C)9.45%. D)7.00%.

A)4.55%. Explanation Because the 7% on the corporate bond is fully taxable, the client receives a net of 4.55% ($70 per bond less 35% in taxes [$24.50], or $45.50 per year). Interest on municipal bonds is tax free, so a 4.55% coupon will result in the same amount of after-tax income.

Kate, age 59, has an investment portfolio exceeding $250,000. She considers herself a moderate to conservative investor. To generate additional income, she is anticipating adding bonds to her portfolio. She lives in a state that does not have an income tax and she is in the 28% federal income tax bracket. Which of the following bonds would be the best recommendation for her portfolio? A)Bond A, A-rated corporate debenture with a 6.50% coupon rate B)Bond B, BBB rated municipal bond with a 3.75% c

A)Bond A, A-rated corporate debenture with a 6.50% coupon rate Explanation Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Kate based on her risk tolerance. Therefore, Bond A would be the best choice. Calculations: Bond A: 6.5 × (1 - 0.28) = 4.68% Bond B: 3.75% Bond C: 8% × (1 - 0.28) = 5.76% Bond D: 2.55% × (1 - 0.28) = 1.84%

Your client in the 25% federal income tax bracket lives in a state where his earnings place him in the 6% bracket for state income tax purposes. If he were to purchase a 4% bond issued by a political subdivision of another state, his total tax-equivalent yield would be A)4.00%. B)slightly less than 5.33%. C)slightly more than 5.33%. D)approximately 12.90%.

B)slightly less than 5.33%. Explanation When an individual owns a municipal bond issued in a state other than his state of residence, although the interest is tax free on a federal basis, it is taxable (at least in all cases on the exam) in that state. Therefore, the tax-equivalent yield here is slightly lower than it would be if we only computed using the federal tax rate. Because that would be 4.0% divided by 0.75 (100% minus the 25% tax bracket) or 5.33%, paying the state income taxes would decrease the yield slightly.

Which of the following statements about municipal bonds is not true? A)Municipal bonds generally carry lower coupon rates than corporate bonds of the same quality. B)The interest on municipal bonds is usually not subject to federal income tax. C)Municipal bonds are generally considered riskier than corporate bonds. D)Municipal bonds are bonds issued by governmental units at levels other than the federal.

C)Municipal bonds are generally considered riskier than corporate bonds. Explanation Municipal bonds are generally considered second only to Treasury instruments in relative safety.

Which of the following choices offers the highest tax-equivalent yield? A)6.2% municipal bond to a corporation in the 21% tax bracket B)5.8% municipal bond to an individual in the 25% tax bracket C)5.0% municipal bond to an individual in the 35% tax bracket D)5.5% municipal bond to an individual in the 28% tax bracket

A)6.2% municipal bond to a corporation in the 21% tax bracket Explanation Corporations receive the same tax break on municipal bonds as do individuals. Therefore, receiving a 6.2% return in the 21% tax bracket is equivalent to 7.85% before tax. A 5% bond to someone in the 35% bracket is equivalent to 7.69%; a 5.5% coupon to someone in the 28% bracket is equivalent to 7.64%; and a 5.8% coupon to someone in the 25% bracket is equivalent to 7.73%.

Your client in the 25% federal income tax bracket lives in a state where his earnings place him in the 6% bracket for state income tax purposes. If he were to purchase a 4% bond issued by a political subdivision of his state, his total tax-equivalent yield would be A)slightly more than 5.33%. B)4.00%. C)slightly less than 5.33%. D)approximately 12.90%

A)slightly more than 5.33%. Explanation When an individual owns a municipal bond issued in his state of residence, not only is the interest tax free on a federal basis but (at least in all cases on the exam) also it is nontaxed in that state. Therefore, the tax-equivalent yield here is slightly higher than it would be if we only computed using the federal tax rate. Because that would be 4.0% divided by 0.75 (100% minus the 25% tax bracket) or 5.33%, saving on state income taxes would increase the yield slightly.

When referring to municipal bonds, the formula of (1 − tax bracket) is found in the computation of A)yield to maturity. B)current yield. C)tax-equivalent yield. D)return on investment.

C)tax-equivalent yield. Explanation The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond's coupon rate by (1 − the investor's tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 − 0.20), or 4% divided by 0.80 = 5%.

The interest from which of the following bonds is exempt from federal income tax? State of California bonds City of Anchorage bonds Treasury bonds GNMA bonds A)III and IV B)II and IV C)I and III D)I and II

D)I and II Explanation Municipal bonds are exempt from federal income tax. Treasury bonds are exempt from state tax but not federal tax. GNMAs are subject to federal, state, and local income tax.

Which of the following is a characteristic of an investment-grade general obligation municipal bond? A)The bond's main source of investment risk is financial risk. B)The bond retains a direct claim on specific property. C)The taxing authority of the issuing government or municipality backs the issue's repayment. D)The bond's periodic interest is paid to investors only when sufficient revenue is collected by the municipality.

C)The taxing authority of the issuing government or municipality backs the issue's repayment. Explanation General obligation bonds are backed by the full faith and credit of the government issuing the debt and are repaid through taxes collected by the government body. The main source of investment risk for a municipal security is interest rate risk. General obligation bonds do not retain a claim on specific property. The government issuing the bonds uses its taxing authority to pay the interest and repay the principal. Revenue bonds, not general obligation bonds, are dependent on revenue collected from the financed project.

A client in the 28% marginal federal income tax bracket invests in a corporate bond with an 8% coupon. To calculate the client's after-tax rate of return, A)divide 0.08 by 0.28. B)multiply 0.08 by 0.28. C)multiply 0.08 by 0.72. D)divide 0.08 by 0.72.

C)multiply 0.08 by 0.72. Explanation To determine a taxable bond's after-tax rate of return, multiply the coupon rate by the complement of the client's marginal federal income tax bracket. The client's tax bracket is 28% (0.28), so the complement is 100% − 28% (1.00 − 0.28) = 0.72.

A client is in the 28% marginal federal income tax bracket and the 3% state income tax bracket. Which of the following investments would produce the highest after-tax yield for the client? A)A AAA rated debenture yielding 7.75% B)A U.S. Treasury note yielding 7% C)An A-rated corporate mortgage bond yielding 8% D)A public-purpose municipal bond yielding 6%

D)A public-purpose municipal bond yielding 6% Explanation Because your client is in the 28% tax bracket, she has to earn more than the 6% on a taxable bond for the yield to be equal to, or higher than, the tax-free bond. That number can easily be calculated because 72% of the taxable amount must be equal to or greater than the 6% return (6% ÷ 72% = 8.33%). The 8.33% is higher than the return on the other bonds listed, so the public-purpose municipal bond would produce the highest retained return. This would be even more appropriate if the issue was tax exempt in the client's state.

Which of the following would be least likely for an investment adviser representative to consider before recommending a municipal security to a customer? A)The municipal security's rating B)The customer's tax status C)The customer's state of residence D)The customer's highest education level

D)The customer's highest education level Explanation The customer's state of residence and tax status are essential when determining suitability for a municipal security because the higher the tax bracket, the more attractive the tax-free yield, especially if there is a state income tax. The security's rating is also critical because it measures the safety and quality of the bond. The investor's education level rarely enters into the suitability equation.

Which of the following statements represents an advantage of a municipal general obligation (GO) bond over a revenue bond? A)A GO bond issuer is required to conduct a feasibility study. B)A GO bond generally involves less risk to the investor. C)A GO bond is not charged against the municipality's borrowing limits. D)Only a facility's users pay for a GO bond.

B)A GO bond generally involves less risk to the investor. Explanation GO bonds are generally less risky than revenue bonds because they are backed by taxes rather than revenues. GO debt is charged against the borrowing limits (similar to the credit limit on your credit cards). That is a benefit to the investor because that limit protects against the municipality getting into debt over its head. It is the revenue bond that needs a feasibility study and collects user fees

When an investor divides the coupon rate of a municipal bond by the complement of her tax rate, she is computing the bond's A)discounted cash flow. B)tax-equivalent yield. C)after-tax rate of return. D)inflation-adjusted return.

B)tax-equivalent yield. Explanation The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond's coupon rate by the complement of the investor's tax rate (1 - the investor's tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 - 0.20), or 4% divided by 0.80 = 5%.

Which of the following investments would provide the highest after-tax income to your client in the 35% federal income tax bracket? A)7% bond issued by Canadian Province M B)8% debenture issued by the LMN Corporation C)6% U.S. Treasury bond D)5% general obligation municipal bond issued by State H

B)8% debenture issued by the LMN Corporation Explanation Only the State H bond is exempt from federal income tax. Using the tax-equivalent yield formula of the muni coupon divided by (100% minus the investor's tax bracket %), we get 5% divided by 65%, or 7.7%. That's a better deal than receiving 6% on the Treasury and paying taxes as well as 7% on the Canadian bond (although you learned that securities issued by Canadian provinces were exempt from registration under the Uniform Securities Act, that has nothing to do with U.S. income taxes). However, with a TEY of 7.7%, your client would take home more with the 8% taxable corporate security. You can also work backward to get the correct answer. Simply subtract 35% tax from each of the choices (other than the muni) and see which is the highest. In this case, 8% minus a 35% tax equals 5.2%—just a bit higher than the 5% coupon on the municipal bond.

A client is trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are equal and your client is in a 28% marginal income tax bracket, which bond do you tell the client to purchase and why? A)The corporate bond because the after-tax yield is 4.50% B)The municipal bond because its equivalent taxable yield is 6.60% C)The corporate bond because the after-tax yield

B)The municipal bond because its equivalent taxable yield is 6.60% Explanation If we compute the tax-equivalent yield of the muni, we see that it is 6.60%, which is a higher return than the 6.25% on the corporate bond. The formula to get this starts by taking the investor's tax bracket and subtracting it from 100%. 100% − 28% = 72%. We then divide the muni coupon of 4.75% by the 72%, and the result rounds off to 6.6%.

An investor in the 28% income tax bracket is considering purchasing either an 8% municipal bond or a 10% corporate bond. Which of the following regarding the bonds is true? A)The yields of the bonds are equivalent on an after-tax basis. B)The municipal yield is higher than the corporate yield on an after-tax basis. C)The corporate bond yield is higher than the municipal yield after taxes. D)The yield difference cannot be determined.

B)The municipal yield is higher than the corporate yield on an after-tax basis. Explanation Investors are interested in their return after taxes (what they get to keep). The two bonds must be compared on a tax-equivalent basis. For example, the tax-equivalent yield of a municipal bond equals tax-free yield divided by 100% minus tax rate. The tax-equivalent rate in this case is 0.08 ÷ 0.72 (100% − 28%) = 11.11%. In other words, a client in the 28% tax bracket would have to invest in a taxable bond that yields 11.11% to get the same after-tax return that the 8% tax-free bond offers.

Your client in the 28% federal income tax bracket currently owns some U.S. government bonds with a coupon yield of 6%. In order to receive the same income after taxes, she would need to buy municipal bonds with a coupon of A)4.32%. B)7.68%. C)6.00%. D)1.68%.

A)4.32%. Explanation Because the 6% on the government bond is fully taxable on a federal basis, the client receives a net of 4.32% ($60 per bond less 28% in taxes [$16.80], or $43.20 per year). Interest on municipal bonds is tax free, so a 4.32% coupon will result in the same amount of after-tax income.

A client in the 30% tax bracket owns a 5% XYZ, Inc., debenture due to mature shortly. What yield in a municipal bond will result in the same after-tax return that now exists has with the debenture? A)2.0% B)3.5% C)1.5% D)5.3%

B)3.5% Explanation The client's tax rate is 30%; 70% of 5% is 3.5%. A nontaxable municipal bond with a 3.5% yield would give the client the same return.

An investor in the 25% federal income tax bracket is considering the purchase of some fixed-income instruments. Which of the following would provide the investor with the greatest after-tax return? A)6% FDIC-insured CD B)4.8% AAA rated insured municipal bond C)5% U.S. Treasury bond D)7% Ba rated corporate bond

D)7% Ba rated corporate bond Explanation The greatest after-tax return is provided by the instrument listed that, after subtracting 25% for income tax, leaves the investor with the greatest amount. Because the Treasury bond, the CD, and the corporate bond are all taxable at the same rate, the 7% bond must be the best deal. Even though the municipal bond is not taxed, its 4.8% net yield is far lower than the 5.25% ($70 − 25% tax) return on the corporate bond.