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Got Tax-Free Income?

By Robert Child, Boca Raton Bond Specialist


May 2012

     If you are an investor looking to protect your income from taxation, you may want to take a look at the tax-free, municipal bond market, especially for investors in higher tax brackets. Interest from most types of municipal bonds is tax exempt from federal income. Most states do not tax interest payments on municipal bonds issued in their state. Of course, there are several variables involved with tax-free bonds, so they may not be for everyone.

     Since 1913, municipal bonds have offered a tax-free source for investment dollars. Tax-free bonds are the backbone for revenue which enables local municipalities to fund public improvement projects, such as hospitals, roads, schools, airports and courts. Municipal bonds pay interest that is exempt from both federal income tax, and, depending on the state you live in, state income tax.  Recognized by the U.S. Supreme Court, this tax exemption results from the theory of reciprocal immunity: States do not tax federal government bond interest and the federal government does not tax interest of state and local government issues.

     There are generally two categories of municipal bonds, general obligation bonds and revenue bonds. General obligation bonds are typically paid from tax revenues such as ad valorem taxes and income tax revenues. Revenue bonds are typically paid back by the earnings generated from the particular asset that the bond issue is used to finance such as toll roads or toll bridges.Once the municipal bond has been issued by the municipality, the secondary market prices the bond according to the bond’s yield and credit risk.  Wall Street underwriters and rating agencies, such as Moody’s Investors Services and Standard & Poor’s® (also known as S&P), use letters to rate the grade of the bonds.  For example, Standard & Poor’s® rates investment grade bonds the highest at AAA because they consider AAA’s most credit worthy with an “extremely strong capacity to meet financial commitments.” Ratings further down the alphabet, for example, AA, A, BBB, etc. are still believed to have the capacity to meet their financial commitments. Credit ratings and definitions can be found on the Standard & Poor’s website. Some bonds may not receive a credit rating from the major credit rating agencies. These bonds, typically called nonrated bonds, may not be rated for a number of reasons, including, but not limited to, the issuer not wanting to pay a fee to the credit rating agency. These nonrated bonds may not be necessarily risky, however, will not carry an investment-grade rating.

     Current interest rates play a role in the pricing of bonds.  In simplistic terms, when interest rates fall, bond prices go up and when interest rates rise, bond prices drop.  Bonds may, or may not, be issued with call features. Call features permit the bond issuer to redeem the bond before the specified maturity date, at a specified price. Similar to refinancing a home mortgage. Should mortgage rates go down, a homeowner may consider a refinance for a lower rate.  Callable bonds operate in the same way. If a bond is called, the issuer would pay the bond holder back his/hers principal sum and then “refinance” the bonds at a lower rate, or pay off the debt early. 

     Many of our clients have structured their investment portfolios to have a prudent mix of equity and fixed income investments that are in line with their financial objectives. The usual complement to equity investments are bonds, and for those investors in the upper tax brackets, municipal bonds may make the most sense.

     Municipal bonds can provide the following benefits to your portfolio:


  • Predictability. Interest is paid semiannually, and bond holders receive their principal intact when the bonds mature. Bond buyers know exactly how much they will earn, and how long until the bond matures.
  • Stability. Investment grade municipal bonds historically have low default rates– As of February 2011, the occurrences of default for high quality municipal bonds are generally very low. “99.97% of all Aaa and Aa rated municipal have generated coupon payments and redemptions as promised over the past 40 years without a single missed or even late payment." (1)
  • Tax Free. The interest earned on most municipal bonds is exempt from federal income taxes, and may be exempt from state taxes in the issuer’s state. Of course, although the interest paid on municipal bonds may be tax-exempt, a municipal bond holder may have gains or losses that are subject to federal income tax on the sale of the bond.
  • Liquidity. Should the need arise; an investor may generally sell almost any municipal bond.

     Bob Child, President of Child Group Wealth Management in Boca Raton FL, has been working within the municipal bond market for almost 40 years. Whether you are a conservative investor looking for monthly cash flow or a more adventurous investor looking for higher yields, Child Group Wealth Management has the intelligence and expertise to guide you.

     If you would like to find out more about municipal bonds, and if you think they may be appropriate for you, please call Bob at 561-869-5225.

 

www.ChildWealthManagement.com

 

Disclosure: Securities offered through vFinance Investments, Inc., Member FINRA/SIPC. The Child Group Wealth Management advisors are registered with National Asset Management, Inc., a SEC Registered Investment Advisor and affiliate of vFinance Investments, Inc., Accounts are carried by National Financial Services LLC, Member NYSE/SIPC, a Fidelity Investments company. National Asset Management and vFinance Investments are not affiliated with the Child Group Wealth Management

Disclaimer: There are risks involved with investing, including loss of principal. Past performance does not guarantee future results. By investing in bonds you may be subjected to price volatility based on fluctuations in issuer and credit quality. When investing in bonds, you are subject, but not limited to, the interest rate, inflation and credit risks associated with the bonds. Bonds may be worth less than original cost upon redemption or maturity. ** Fixed Income investments may limit a client’s risk exposure by receiving consistent cash flow on their investment depending on the terms and rating of the investment, no matter what the market value of the bond is at that time. So, even thru volatile times, as we have seen these past few years, while the principal value of bonds will fluctuate with the markets, most bond investments are locked in at a fixed interest rate of return.

* Interest payments are determined by the interest paying ability of the underlying guarantor. Principal for fixed income products are generally paid upon maturity date unless called prior to maturity by the underlying guarantor. Investments in Fixed Income products may lose principal value if sold prior to maturity. ** Please discuss your specific investment objectives, time horizon and risk tolerance with your investment professional prior to investing.

National Asset Management, Inc. ("NAM") is a registered investment advisor with the Securities and Exchange Commission. NAM provides fundamental investment management services to investors. The views expressed contain certain forward looking statements. NAM believes these forward looking statements to be reasonable, although they are forecasts and actual results may be meaningfully different. Actual events may cause adjustments in portfolio management strategies from those currently expected to be employed. This material represents an assessment of the market at a particular time and is not a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any security in particular. No representation is being made that any investor will or is likely to achieve profits or losses.

Diversification:  Diversification does not guarantee against loss.  It is a method used to help manage investment risk.


(1) Safety of Investment Grade Bonds, Asset Dedication White Paper Series,
http://assetdedication.com/public/uploads/pdf/Asset_Dedication_White_Paper-Safety_of_Investment_Grade_Bonds.pdf  (February 2011).

 

 

 
 

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