Who may consider them, why you may consider them, and how they work.
Generally considered the second safest asset class behind U.S. treasuries, Municipals (also called Munis) offer income or appreciation that is exempt from regular Federal income tax, and generally State and Local income taxes (based on the location of the issues). Bonds are purchased by individual investors in high income tax brackets, and are favored particularly by those in high combined federal and state income tax brackets. To demonstrate, to compete with a municipal yielding 5%, a top bracket investor in the state of California would need to realize a taxable yield of 8.89%; in New York State, 8.35%; in Texas, 7.69%; and in Massachusetts, 8.12%.* Combine that return with an understanding of the historic safety of municipals relative to other asset classes, and generally good liquidity, then you are well on your way to answering the question, "Why municipal bonds?".
Who should consider municipals?
Certain Federal tax advantages make municipal bonds particularly attractive to higher income individuals. Their high degree of safety relative to other asset classes, and in many cases, State Tax Exemption, make municipals attractive to investors who reside in states with high income tax levels who desire relatively safe, predictable income. A less attended to area of the municipal market, zero coupon munis can offer working individuals who do not presently need additional income from their investment portfolio, with a relatively safe vehicle for appreciation that is exempt from federal and state taxation.
How do municipals work?
Below are details about pars, premiums, discounts, zero coupons and taxable munis.
Par Bonds: In general, the simplest municipal structure to understand. $100,000 invested in a 5.0% coupon bond available at Par ($100) would pay $5,000 per year until its maturity date when it repays the $100,000 initially invested. Notice that the coupon and yield are identical when looking at par bonds.
Premium Bonds: In our experience, a general reluctance by investors to pay substantially over par for municipals can create opportunities for those willing to consider premium bonds. Premiums are municipals that have above market coupons that compensate the holder for investing some amount more than the holder will receive at maturity. Think of premiums this way: If sometime ago, municipals issued in the primary market were paying 10% coupons, then interest rates began to fall, and had dropped all the way from 10% to 5% ... how would the market compensate the 10% coupon holder if he/she needed to sell? The answer is simple, the market would pay the holder of the 10% coupon a premium, or some price that is more than new holder will receive at maturity. That will decrease the bonds yield from its 10% coupon rate, to some level closer to the 5% presently available in the marketplace. Notice that premium bonds always have a yield to maturity that is lower than their coupon rate. Opportunistic municipal investors who wish to generate a high level of current income may consider premium municipals.
Discounted Municipals: A discounted municipal has 2 components that make up yield: the coupon, and the appreciation of the discount when the bonds are called or mature. A discounted muni will always have a yield to call or yield to maturity that is higher than its coupon rate. Investors must consider the tax implications of discounted bonds. Frequently, the coupon portion of the yield may be tax exempt, but the appreciation, under some circumstances, may be taxable. Investors who are not as concerned with immediate current income, but who may benefit from a combination of moderate income and some appreciation might consider discounted municipals.
Zero Coupon Municipals: Zero coupon municipals, or zeros, pay no income but are bought at a discount and mature at par ($100) at some point in the future. Generally, long term zeros are bought at a substantial discount to par, and short term zeros are purchased at a more moderate discount. Investors with high current income from other sources may find zeros are an effective product for their portfolios. Maturities can be purchased to coincide with planned retirement, then rolled into appropriate income producing alternatives. Zeros with maturities that coincide with a child's college years may be appropriate for educational savings. In our experience, zeros tend to offer a yield advantage over coupon bonds with comparable rating and maturity features.
Taxable Municipals/Build America Bonds: While taxable municipals have been available for some time, the creation of Build America Bonds has increased dramatically the size and number of participants in this market. Suitable for lower federal income tax brackets or tax deferred retirement accounts, taxable municipals can provide a high degree of current income, and often, yield pick up over treasuries, CDs and comparably rated corporate bonds.
*Tax rates are for 2009 and assume AGI for joint filers in excess of $372,950.