In the end, just be happy with the yield of the bond purchased and dont go crazy if the bond price drops. If you hold the bond until it is called or matures then you will get the face value back to avoid lost of principle except for the premium paid. I like to sort all the munis for my state with YTW in descending order which will display the highest yield at the top of the list. This makes it easier to select a bond.
You can buy bonds with different call dates and maturity dates to create a bond ladder. This way your bonds will return your principle at different years so that all of your money is not locked to a specifc year. I also look for bonds to pay on different months of the year so that I will get bond payment every month. This is not a show stopper but it is nice to get payments every month.
If you have to pay a premium then pay at most dollars. When this bond is called or matures, only the face value is returned to you. If you paid a premium then it will result in a lost of principle. This is not a big deal if especially you are happy with the yield and the interest you received. You have a similar philosophy as my late father who only invested on bonds after being burned by stocks.
He too always bought bonds to the longest maturity because in his experience, they often were called early. Hard to know if that will continue now that interest rates are so low. Thanks for a great post. Can you explain how these double taxation free bonds help with keeping your income within a certain marginal tax bracket?
Or offset the risk of being in these higher tax brackets? Every dollar you invest has the potential to generate MORE passive income, putting you in a higher income tax bracket. Instead of buying assets that produce income which are then taxed, you can buy a growth stock higher risk or a zero coupon municipal bond lower risk to produce zero income only until sale or maturity.
Got it. We are not lowering our tax burden in the current year, but are potentially lowering it in future years. Can you maybe talk about how this plays into your taxes? The higher your marginal federal and state income taxes are, the more attractive municipal bonds are. You may pay long term capital gains taxes on any profits you make on the municipal bond principal amount. It depends on how long you hold and at what price you bought compared to the original issue discount. Why is it a double tax free return? Is this a reference to federal AND state taxes?
Also, at what combined tax rate would you consider to be the lowest rate where this would make sense? For someone with a year mortgage at a low interest rate assume 2. Federal and state. In a previous post, you mentioned looking for muni bonds that can throw off interest payments equal to your mortgage payment to effectively live for free.
Regular, non-muni, zeroes require you to declare the accrued interest in a calendar year as income and therefore potentially pay taxes on it. How do you plan to account for the zero munis increase in value over time in your net worth calculation? Great article Sam. New to this investing so have learnt a lot from the article. Absolutely wonderful analysis!
One question though.
Zero Coupon Municipal Bonds: Tax Treatment
How do you buy individual bonds, meaning who do you send the check to? I opened a Fidelity brokerage acct online two years ago. I now buy bonds on my own to save money. No more human interaction to transfer money or to buy bonds. I have total control of my bond portfolio! If you live in a tax free state like Florida then you can buy muni bonds from any state. Only zero munis have no income tax each year, correct?.
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Great read, loved this article and the way you made these bond concepts easy to understand. The junk bond market in the US is roughly 1. Do you feel investors of these bonds could get wiped out if we see a downturn in the economic because they have such poor credit ratings? Think about this from a mortgage perspective.
Would you wait until to re-finance? Recent credit issues have been skewed towards G. There are no more AAA rated monoline insurers after the financial crisis.
Only the income is federally and potentially state tax free. A train system could stop working due to an explosion, natural disaster, terrorist attack. But if that stuff happened, people would still pay their taxes. In my case, I like to buy 5 tranches of a position over a month period of time once I believe there is value in a particular asset.
If it does, we are either screwed or in a raging bull market, which is fine for stocks and real estate. The vast majority of revenue for a Local G. The remainder is generally state pass through — which in tough times gets cut quickly.
How are municipal bonds taxed?
I agree the risk is relatively minor comparatively, but look at how many people are moving out of Chicago as they dramatically raise property taxes to deal with their budget deficits. Puerto Rico is the ultimate example of this. A Toll Road authority could have full rate setting authority and simply raise the toll. And look what happens where there is an unfortunate tragedy, like the recent train systems in NY. Interest coverage ratio and days cash on hand are important metrics for revenue bonds.
Multiple tranches makes sense.
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Stay flexible. Many bond investors just buy and hold and do nothing until their bond comes due. But, they were only there for a brief period. Another popular use of Zero Coupon bonds is to fund college tuition. How are you guys investing after the sell off? Any worried clients? How high do you guys think the 10 year will go in the short term?
Yes, clients are worried. There is sticker shock when they see bond prices down so much so quickly. Clients can see their equities down significantly and feel OK, but, if their bonds are down just a bit they get very nervous. Even though most bonds have a baseline of par at maturity as a worst case scenario. I think a big wild card is how much foreign governments have to dump UST to support their currency as dollar rises. Very interesting.
Hopefully your clients will have the appetite to buy more with higher yields. Given the 10Y yield is so much higher than foreign yields, I would think foreigners would find our assets more attractive. At the end of the day, the muni market is only down about 3. Lots of great insights above so I can see the appeal. I have bought some muni ETFs this year though. And as people buy more shares, it would drive up the share price? And I as the issuer would set the yield and this the sell price at maturity?
Or is it like savings bonds where EE bonds are sold at half the face value and redeemed at face if held to maturity. Sorry for the interrogation. I love to learn not just how investments work but WHAT they are and what exactly is going on when you invest in something. If not, nobody would buy it.
A zero coupon is locking in your upside if held to maturity. I grasp why a zero coupon bond would provide more value than a coupon payer. I grasp total return too. It sounds more like a CD, but based off loaning money to a municipality. Okay, NOW am I getting the technical details of how bonds work? I think I might have just walked myself through it. I like to know how things work. A lot of the fluctuation has to do with the expectation of inflation, growth and interest rates. The other consideration is the credit worthiness of the borrower, which is why munis getting hit harder than higher yield bonds is the opportunity imo.
But as with all investments, I leg in with multiple tranches. Is there any concern that the CA pension crisis could affect future bond payments? In a bull market where municipalities are flush with cash due to tax revenue and operating revenue from the facilities, the chances of default are even smaller than the table above. Long time reader, First time poster. You really caught my interest with this piece, since I work on the FI desk for a large retail firm.
Demand far exceeds current supply, and you can pick up enough yield to cover state taxes and get another bps on top of that Texas, Florida, Ohio, etc. If you feel that this is a threat, then zero coupon bonds are less attractive at the margin because of the reinvestment ability that BK listed in straight coupon-paying bonds as interest rates rise — conversely, no reinvestment risk if yields fall. Thanks for another excellent clarification post. Would you recommend that individuals begin buying bonds as they approach FI so that they have the cash on hand to begin building up the safer investments?
No problem. The worst year for bonds was These two facts should prove attractive for those who want less volatility, more assurances, and more income. I started my zero coupon muni bond ladder in when I got a large insurance payment. I put the bond portion of my portfolio all into individual bonds rather than a fund.
Every couple of years I refill the ladder. Perhaps not the worst time to go into some bonds? Hi David, nobody really knows how long the good times will last. Politicians have proven in the past did not deliver on their promises. Therefore, it seems likely that the market is getting ahead of itself with regards to what Trump is planning regarding corporate tax cuts, Government spending, etc. I suggest reading my recommended asset allocation post and following a specific investment cadence.
Sam, random question. Where do you get the images for your blog? How do you ensure images are in the public domain? Thinking of starting my own blog. Any books you would suggest? Your email address will not be published. Don't subscribe All Replies to my comments Notify me of followup comments via e-mail. You can also subscribe without commenting. Sign up for the private Financial Samurai newsletter! How can you resist? Are you on track?
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Sign up for free to plan for your retirement future. Tweet Share 8. Pin 3. Share 2. Comments Sam, this was a great primer on zero coupon municipal bonds. Thanks for the in depth break down, interesting stuff! Not on topic, but the day you shutter FS will be a terrible day. Hola Fritz — Thanks for the kudos. Since I am in a state with no state income tax, I prefer the higher yield muni funds. Hope this makes sense. Sam, Thanks. Hi Sam, Would you say the same for paying down student loans principal in this rising interest rate environment? Yes, similar line of thought. Excellent overview munis!
Buy what you know. Tax exemption. Make sure it is totally tax free. Check the bond details. Insured If a muni bond is insured then the bond is safer. Call dates, mature dates and month interest is paid. Price of the bond. This is not a big deal if especially you are happy with the yield and the interest you received Adam.
I have been trying to determine whether zero-coupon municipal bonds are subject to market discount rules for taxation purposes. In short, is the buyer of a zero-coupon muni held to maturity ever subject to federal taxes other than the alternative minimum tax?
Perpetuity represents the value of cash flow over time - a lot of time. While good for savers, higher interest rates could drag on consumer spending in the year ahead. Europe's suddenly slowing economy, triggered by trade disputes and limp domestic demand, could complicated the European Central Bank's plans to tighten monetary policy later this year, according to a former German central banker now chairing Switzerland's biggest bank. All rights reserved. Log In. Account Preferences Newsletters Alerts. Access insights and guidance from our Wall Street pros. Find the product that's right for you.