What is a Zero Coupon Municipal Bond?

Municipal bonds, or “munis,” are a debt instrument issued by government entities, such as cities, counties and states.  Generally munis are used to generate capital for public improvements, such as sewers and roads.  Munis are similar to a corporate bond in that they are rated by credit agencies such as Moody’s and S & P.

Most municipal bonds have a coupon rate, which pays a regular dividend during the term of the bond until maturity.  However, zero coupon municipal bonds were introduced in the early 1980s for investors who were not interested in a regular income stream, but rather wanted the benefit of purchasing a short-term, low risk bond with a single interest payment at maturity.  Zero coupon municipal bonds offer no interim “coupons,” or dividend payments.

Benefits of a Zero Coupon Municipal Bond

There are many benefits for investors who allocate part of their wealth into zero coupon municipal bonds.

• Tax Free – The government wants to encourage investment in public works.  Thus, most zero coupon municipal bonds are tax exempt, making them an attractive alternative to corporate bonds.  Generally, an investor within a higher tax bracket will benefit the most from a tax free zero coupon municipal bond.

• Better Credit Rating – Zero coupon municipal bonds are rated by at least one of the major rating agencies.  A majority of all zero coupon municipal bonds generally are good quality and are rated A or better.  In fact, many zero coupon municipal bonds carry insurance guaranteeing from default.  These bonds usually are rated AAA or better.

• Low Minimum Investment – Since zero coupon municipal bonds offer only a single interest payment at the maturity date, they are usually heavily discounted from the face value.  For instance, a 20-year, $20,000 zero coupon municipal bond may sell for about $6,700.  At maturity in 20 years the bond will pay $20,000, usually tax free.

• Liquidity – Zero coupon municipal bonds have many ranges of terms.  There are many short-term zero coupon municipal bonds in the 3 to 5 year maturity range.  This offers investors great liquidity in being able to sell the bond if they are in need of cash during the term.

Where Can You Buy a Zero Coupon Municipal Bond?

Investors can purchase zero coupon municipal bonds directly from the issuing government when the bonds are first issued.  There are many websites that offer information about new zero coupon municipal bond issues, such as the US Department of the Treasury.

However many investors do not wish to perform the research for newly listed zero coupon municipal bonds and would rather purchase through an investment brokerage house.  Most major brokerage firms deal with secondary sales of zero coupon municipal bonds.  Check with your investment broker if you are interested in putting part of your wealth in zero coupon municipal bonds.

The key feature of a private purpose bond is that they are solely used to help finance private investments and amenities. Comparatively, a public purpose bond is exclusively for investments that benefit the public, i.e. public facilities or projects that benefit a sizeable community.

The reason why The Tax Reform of 1986 led to the separation of municipal bonds into two types was for a change in the taxation regulations. The taxation regulations are currently quite clear and state that: Private Purpose Bonds are applicable for taxation unless exempted (which is rare). Public Purpose Bonds are exempt from federal taxation.

The reason why these types of bonds are so popular with investors who have high incomes is because of their extremely favourable tax implications – they are exempt from federal taxes and in most cases state taxes too.

A word on the security attributes of a municipal bond fund – although they are backed by the government and are considered low risk rating, municipalities have in the past declared bankruptcy and avoided payouts altogether. So although they are generally low risk, investors should be aware that there are ways that you could lose out should something inadvertently go wrong.

Simply put, a revenue bond is issued by a locality to financially support a specific public works project. The revenues that this public works project makes are then used to further support the projects existence. Revenue bonds are considered by many to be the second most secure type of municipal bond and are sometimes referred to as municipal revenue bond.

A special assessment bond is firstly a type of municipal bond, which as we have covered in previous articles are debt security bonds issued by a state or municipality to finance capital expenditure. Special assessment bonds are used to financially back a development project and the interest is payable to the investors through taxes levied on the community whom are supposedly benefiting from the specific assessment bond funded project.

In essence, this is a type of municipal bond that is repaid by taxes collected from those who are appreciating (hopefully) the development or service that the project was funded for. An assessment bond is also sometimes referred to as a special purpose bond since the projects that they often fund are for the good of the community. An example; A local community sees their local facilities improved and a recreation facility produced. This not only increases the value of their homes as their neighbourhood sees a rise in value, it benefits them as individuals. However, with increased value come increased taxes, which of course are used to fund the project in the first place.

There are three most common types of repayment source for municipal bonds, these are;

• General Obligation Bonds – These are well known for their security and low interest rates, the agreement is to repay in full the credit given by the issuer.
• Revenue Bonds – These are most common in active, working projects and investments as the agreement is to repay based of a channel of past, present and future incomes. An example would be a share of the income a power plant may generate.
• Assessment Bonds – These involve the repayment based on taxes, usually land taxes or property taxes located within the domicile of the issuer.

There are a number of other types of municipal bond repayment sources but the above three are the most common.

Depending on the value or importance of the municipal bond, you will quite often see external or third parties involved in reviewing and guaranteeing a repayment source or agreement. Typically the agreement is reviewed and then rated by the external agency, both sides of the municipal bond ie; investment holder/issuer will receive a copy of the review and the assigned bond rating.

In the United States of America there are three rating agencies most commonly used, these are; Fitch, Moody’s and Standard & Poor’s.

Breaking this down into more manageable chucks; typically, interest payable on municipal tax bonds is usually exempt from all federal taxes, so too local and state taxes. Of course it does depend on the state that the bonds were initiated in and subject to other restrictions but in essence; municipal bond investing quite often has an attractive tax-exempt quality.

The calculation of whether municipal bonds become taxable is usually through which type of project it is funding. For instance; projects initiated for the greater good of the public, for example; a railway network, would more than likely be a tax free municipal bond as its development is in the best interests of the general public and everyone can benefit from, not just a private citizen or their cause. This compared to projects either partially or fully benefiting an individual or group of private parties, usually called private activity bonds, are usually subject to federal income tax.

As we have already discussed in a previous article, the legislation surrounding the tax-ability of municipal bonds and the income that they provide is extremely complex. As bonds are usually always certified by a professional law company, it should be disclosed whether they are taxable or indeed tax-exempt before they are even offered to the market. You should keep in mind that not all municipal bonds are tax-exempt, some are unfortunately fully taxable. Always check thoroughly before considering investing in municipal bonds.

When a municipal bond is initiated, the issuer normally receives a cash payment in exchange for an agreement to provide the investor who provided the cash payment, a repayment over an agreed time period. The standard repayment periods for municipal bonds can be anything from six months to 10-30 years, perhaps even longer. The shorter periods are quite rare and you would be hard pressed to find investments for such a short period of time unless either the sum being borrowed is low or the repayment period can be guaranteed. Typically, 20+ years is the industry standard.

The purpose of municipal bond investing would be to use the investment from a bond sale to pay for the project that it is being invested for, typically this is a project or a long term capital investment or development. Depending on the stipulations of the bond offering, all of the capital raised from a bond sale may be used immediately or provisions put in place to spread it over a period of time.

A municipal bond, or “muni” as it is sometimes referred to is a debt security issued by a municipality, country or state to fund its capital expenditures. It’s important to firstly say that municipal bonds are usually exempt from federal taxes and most state and other local taxes. The only consideration however is that you should really reside in the state that the bond is issued as this increases the chances of keeping your municipal bonds tax-exempt.

Investors who agree to buying municipal bonds effectively loan money to the issuer in exchange for an agreed number of payments over a prearranged time period. At the end of this period, the bond reaches what is called the bond maturity date and the investor receives (if all goes well) the return on their investment including the interest allotted over the time period.

There are quite a number of uses for municipal bonds. For example they may be used to finance such developments as the construction of road networks such as highways or academic schooling facilities.
Perhaps the most common reason people invest in “munis” is because of their extremely favourable tax implications. They are most popular with high income earners as the return on their investment is larger due to the rewarding municipal bond rates they are entitled to.