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Buying Tax Exempt Bonds
Premium is amortized during the bonds life term until maturity or until it is called, which makes municipal bondholders subject to being penalized double.
- You can buy coupon bonds at a premium, only to be aware that bonds can be called at a lower price than the premium price paid).
- Losses are not deductible against other capital gains.
The non-deductibility of the amortization is unique to tax-exempt bonds, and you should be aware that you might be liable for taxes because of gains from buying bonds at a discount and through the process of amortization of a premium.
To illustrate this process, let?s suppose that you buy a tax-exempt bond at a premium of $1,200 and after 5 years you sell it at the same price. As a result of having had to amortize or “write down” premium all this time, the adjustment base for a tax-exempt bond is less than $1,200. Then one incurs in a taxable gain between the adjustment base and the selling price.
Municipalities many times issue serial bonds which are a group of bonds with different terms of maturity within the same edition.
Take into account that with a serial issue, you may choose maturity date when the issue is finally sold in the market. If you pay taxes in the lower marginal tax bracket, first you should compare taxable bond yields against those of a municipal bond before investing.
The Bush Jobs and Growth Tax Relief Reconciliation Act of 2003, signed into law on May 28,2003, reduced the amount of taxes that shareholders pay on the receipt of corporate dividends. Shareholders are taxed on their dividend income at a rate of 5 or 15 percent, depending on their marginal tax bracket.
The prospect of reduced taxes on corporate dividends has had a marked effect on the bond markets, especially municipal bonds. Municipal bonds whose interests are tax-exempt are more directly affected by tax-reduction over dividends, because the advantages of being exempt of tax payment on interests is reduced drastically.
Municipal bond investors are usually attracted to contractual tax-free interest payments and the return of principal at maturity. In other words, municipal bond investors search to preserve their incomes and capital.
Stocks that pay dividends offer municipal bonds along with the possibility of capital appreciation (or, on the downside, capital loss). Some other advantages of common stocks about municipal bonds could be not being so obvious. Costs of transactions are greater for municipal bonds than for stocks, making bonds more conductive to buy and hold to maturity rather than as a trading investment..
Spreads (the difference between bid and ask prices) in stocks have dwarfed to cents however spreads in municipal bonds are considerably larger. Consider following spreads of two municipal bonds sold in January and February 2003 respectively.
Calvert County Pollution Control Bought $60 sold $100
5.55% 2014
Boston Walter & Sewer Bought $100 sold $129
10.875% 2009
Besides the excessive markups in prices the market of municipal bonds is rather less liquid and less negotiable than the stock market.
Many municipal bonds have a call feature that allows the issuer to re-buy their bonds before maturity and many times at par price. Any municipal bond bought at premium price (above $1,000) with this kind of call feature presents great risks to investors. If bonds are called at par the investors will not receive interests to cover the premium, leaving them short in principal investment. With these potential pitfalls in the municipal bond market, dividend paying stocks with the new reduction in federal taxes on dividends become much more attractive if you are seeking income and the potential for capital growth.