Tax-exempt bonds include municipal bonds and Treasury bonds. Municipal bonds are issued by local or state government agencies and can be general obligation or income bonds. Treasury bonds are issued by the US government and are considered risk-free. Bond ratings range from Aaa to D, with D being in default. Call provisions allow for tax-free withdrawal before maturity. Risks include lower yields, interest rate fluctuations, and call provisions.
There are a wide variety of bonds available that fall under the tax-exempt bond category. The most commonly traded are municipal bonds (or munis) and Treasury bonds. Munis are exempt from federal taxes, and Treasuries are primarily exempt from state and local taxes. It is important to be aware that your personal wallet may require a portion of your interest to be subject to an alternative minimum tax.
Munis are issued by some government agency, whether local or state. Tax-exempt bonds issued by municipalities are general obligation bonds or income bonds. General obligation bonds are issued for any project within the boundaries of the local or state authority. These bonds are usually the safest, with the lowest risk. As a result, their interest rate may be lower than that of tax bonds.
Income vouchers are issued for specific projects. Common projects are airport improvements, highways and transportation, hospitals, housing, local improvement and development (LIDS), parks and recreation, prisons, school districts and higher education, water, utilities, veterans welfare, etc. financed with municipal bonds and are valued according to their risk factor.
Interest payments also vary with tax-free bond instruments. There are no bonds, which means that the interest payment is met when the bond matures. These bonds are purchased at a steep discount and mature to full value. Interest payments on most other tax-exempt bonds are paid semi-annually with principal repaid at maturity. Low risk bonds are insured by MBIA (Municipal Bond Insurance Association).
The safest investments of tax-exempt bonds are US Treasuries. These securities are debt obligations issued and guaranteed by the United States government. They are considered risk-free and, as a result, have lower yields than other securities. Treasuries are exempt from state and local taxes. They come in the form of bonds, bills, banknotes, stripes (separate negotiation of registered interest and principal of securities), with the following options:
short term bills
intermediate notes
long-term obligations
inflation-linked securities or Treasury Inflation Protected Securities (TIPS)
Moody’s or Standard & Poor’s classifies all bond instruments as tax exempt. These ratings range from Aaa to C or AAA to D accordingly. A “D” rating is already in default. The opportunity for liquidation is strongly linked to these ratings.
Most contracts include a call supply. This allows you to withdraw the bond tax-free before the maturity date. The bondholder will benefit from this option when prevailing interest rates fall below the rate paid by the bond.
Lower yields, interest rate fluctuations, and call provisions are the only risks involved in tax-free bond instruments. The quality, liquidity and safety of these instruments make them particularly suitable for the conservative investor.
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