Municipal Bond Yields: Tax-Exempt!

2007-03-08 10:33:40

( Legal )



Municipal bonds, as the name suggests, are bonds issued by municipalities. The main draw of these bonds is their tax-exempt status. Municipal bond yields are safe from the taxing authorities, whether on the state level or the federal level. The IRS cannot collect taxes on municipal bond yields.

Why are municipal bond yields exempt from taxes? For the simple reason that the funds extracted from issues of municipal bonds are mostly the ones used to pay for public projects. Without these funds, projects such as schools, highways, and water systems would not exist. So, to entice the public to invest in municipal bonds, the US Congress exempts municipal bond yields from federal income taxes.

For instance, let’s say you want to buy a bond. If you were choosing between a corporate bond and municipal bond, and both of them paid 4% interest, the obvious logical choice would be the municipal bond; it would have the highest yields between the two bonds due to its tax-exempt status.

In reality, of course, the choice is not quite that simple. Corporate bond yields are usually higher than those of municipal bond yields because the latter have a built-in tax advantage. Recall that bond yields change at differing levels of risk; a bond with a higher risk of default will offer to pay a high interest rate than one with less risk.

Municipal bonds are most attractive to investors from the highest income brackets – the tax cuts are considerable here.

If you are looking into the possibility of investing in municipal bonds, you might want to explore money market funds as well. Money market fund yields can often equal bond yields, although sometimes they are lower. They are also usually classified as low-risk, since the time horizon for your investment is relatively short-term. If you are looking to make your money grow with the least amount of risk possible, consider both municipal bonds and money market funds.


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