Tax Exempt (Free) Investing
In our latest series of post we have been talking about tax rates and the importance of meeting this responsibility. However it is time we start talking about being tax efficient when it comes to investing and the best way to start this conversation is with tax exempt municipal bonds.
What are Municipal Bonds?
Municipal Bonds are debt obligations issued by government identities that are below the state level of governance; like cities and counties. The purposes of these bonds are to finance the infrastructure and service needs of the municipalities (issuer) like education, transportation, healthcare, utilities and housing.
Main Types of Municipal Bonds
- Assessment Back Bonds: these are bonds funded by the collection of local property taxes.
- General Obligation Bonds: these are backed by the full faint and trust of the issuer. This kind of municipal bonds are basically funded by the general taxes that the city collects; and the implied power to raise taxes in the future.
- Revenue Bonds: these are backed by a specific source of municipal income like the revenues produced by a toll road, not by general tax collections.
Municipal debts are typically issued in multiples of $5,000 (face value) and they may have long or short term duration (notes). But the most important quality we are going to discuss about municipal bonds is their tax exempt characteristic.
Tax Exempt Investing With Municipal Bonds
The key and most important difference between corporate and municipal bonds, is the tax exemption that most municipal issue have, which give them a distinct investing advantage. Investing in municipal bonds give their holders an instant capital gain tax discount; which present a unique arbitrage opportunity especially against corporate issuance known as tax equivalent yield arbitrage.
Tax Equivalent Yield
The tax equivalent yield is an after-tax arithmetic calculation between both bonds coupons rates; since they cannot be compared directly, because of the tax consequence. The after tax equivalent yield equation looks as follows:
Yc = Ym / (1-R)
Yc: corporate after tax equivalent yield
Ym: municipal yield
R: capital gain tax rate bracket
The municipal effective yield stays the same, while the corporate effective yield decreases because of the tax burden at the federal state and city level; like in New York City, the very reason why we must discuss the versatility of Puerto Rican Municipal Bonds.
Puerto Rican Municipal Bonds
Municipal bonds from Puerto Rico are triple tax exempt in any state of the nation, unlike other municipalities where the tax exemption only applies to the residents of the issuance state. Puerto Rican Bonds are exempt everywhere and usually have an average higher coupon because of the increase risk exposure.
Puerto Rican bonds are riskier for many reasons:
- Very slow to negative, economic and employment grow.
- Unsustainable budget deficits with incredible high level of debts.
- Unfunded forward obligation in their balance sheet.
However, even with a lower quality of issuance as this day the Puerto Rican government bonds have meet most of its debt obligations (interest payments). Higher yields, triple tax exemption nationwide and a good track history make Puerto Rican bonds really popular among municipal bond investors.
Fast Money Portfolio: Puerto Rican Bonds
Case Study Time
Develop an excel spreadsheet that can calculate the comparable after tax equivalent yield between corporate and municipal bonds (an after tax equivalent yield calculator, solver).
The Bottom Line
Investing in tax free (exempt) securities like municipal bonds is a very simple way to produce tax efficient returns without the complications of a corporate structure. Much like investing in a Roth IRA, gains produced by municipal bonds receive special tax treatment which increases the total effective market return of your investment.
Important Note: Short term capital gains produced by the trading of municipal bonds are not tax exempt; only interest payments are.
Do you hold any position in the municipal bond market?