The tax-exempt sector is the market comprised of investment vehicles exempt from federal taxes. The majority of investments in this sector are municipal bonds, which cannot be taxed because U.S. regulation forbids the federal government from taxing debt assets offered by local and state government agencies. These tax exemptions offer investors motivation to purchase low-yield government bonds rather than higher yielding corporate fixed income securities.
Most municipal bonds (munis) are tax-free. However, the tax status is subject to how the bonds are utilized. In addition, several municipal bonds, as well as other tax-exempt investments, offer lower yields than taxable investments.
The tax-exempt sector is the municipal bond market where local and governments issue bonds to raise funds to pay for various projects. Bonds issued in this sector are not subject to federal income taxes.
Most municipal bonds (munis) are tax-free. In addition, several municipal bonds, as well as other nontaxable investments, offer lower yields than taxable investments.
<>What are Municipal Bonds<>
Municipal bonds are debt assets issued by municipalities, states, airports, school districts and other public entities to fund public projects such as the schools, highways, public housing, sewer, water systems, energy utilities and hospitals and to fund government operations.
Municipal bond yields usually have a lower yield as opposed to taxable bonds because of the tax-exempt status. The interest paid on munis varies by state and purpose. If an investor purchases bonds issued in their state, the interest is also exempt from state income taxes.
Municipal bonds lower the risk of default and shield the impacts of stock market volatility by providing higher returns than most other asset classes. Historically, high-yield municipal bond funds have outperformed equities and corporate bonds. Traditionally, investment-grade and high-yield municipal bonds have correlated very little with most of the other asset classes. At times, the correlation was zero, which proves munis offer better portfolio diversification.
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<>Types of Tax-Exempt Bonds<>
There are two types of tax-exempt bonds classified by how the money borrowed is paid back. They are general obligation bonds and revenue bonds.
General obligation bonds are backed by the full faith and credit of the issuing entity. Government issuers offer a guarantee since its taxing authority typically raises funds to repay any bond obligations. Issuers that have a strong tax base are usually highly rated and deemed secure.
Revenues derived from tolls, rents or charges from the infrastructure built back revenue bonds and are used solely for the payment of revenue bond obligations. Revenue bonds are safer if the revenue supporting them is at least double the amount of interest that needs to be paid out.
<>Municipal Bond Issuers<>
Most bonds carry interest at either a fixed or variable interest rate, which can be subject to a cap known as the maximum legal limit; some bonds may be issued solely at an original issue discount, or 0% coupon.
Bond repayment periods range from a few months to 30 years or longer. Tax regulations governing municipal bonds normally require all money raised by a bond sale to be spent on capital projects within three to five years of issuance.
<>Risk<>
Bond coupon payments may be tied to a floating interest rate that resets periodically or fixed. The probability of repayment is determined by an independent reviewer, or rating agency. The three main rating agencies for municipal bonds in the U.S. are Standard & Poor’s, Moody’s, and Fitch.
History
In 1812, the first municipal bond, a general obligation bond was issued by the City of New York for a canal. After the civil war, significant local debt was issued to construct railways. The panic of 1873 and an economic decline temporarily halted the rapid growth of municipal debt.
Reacting to widespread defaults, new state statutes were passed that limited the issuance of local debt. The U.S. economy recovered and municipal debt increased through the early 1900s. The great depression of the 1930s halted growth. However, in the 2000s, this sector has exploded and is popular among investors that use tax-free investments as part of their investment strategy.