What Are Private Activity Bonds?

Private activity bonds are issued by a governing agency, such as cities or states, for the purpose of helping raise money for a private company.  Generally, municipal bonds are issued for public works such as streets and sewers.  But other private entities that provide a service to the general public may be eligible to receive special private activity bond funds.  Groups such as zoos, hospitals, and professional baseball stadiums are examples of private activity bonds.

Considerations of Investing in Private Activity Bonds

Though private activity bonds are issued by governing agencies, they do not always carry the same tax advantages.  Regular general obligation municipal bonds offer tax exemption status for interest earned.  This can be an attractive advantage to high tax bracket investors.  However, since private activity bonds are allocated to the benefit of non-essential works and other private companies, they are subject to the alternative minimum tax on all interest earned.

Investment Strategies for Private Activity Bonds

1. Tax Considerations – If you are an investor who also wishes for the tax advantages of a tax free municipal bond, look for a private activity bond that offers tax exempt status.  Some private companies that are non-profit and provide a higher importance public service will be eligible for tax exemption with their private activity bond.  Investors within a higher tax bracket can benefit most from tax exemption.  However, investors in lower tax brackets may benefit more by buying private activity bonds with an alternative minimum tax obligation.
2. Higher Yield – Private activity bonds generally do not carry the financial backing of the issuing government.  However, that doesn’t mean that private activity bonds are generally rated lower by the main rating agencies.  You can still find private activity bonds with a reasonable yield rated at A or higher.
3. Where to Buy – Investing in private activity bonds is easy for the investor who knows where to look.  Private activity bonds are issued directly from governing entities just the same as regular municipal bonds.  Check with websites like the US Department of Treasury for information about newly released private activity bonds.  You can also purchase private activity bonds through most any major brokerage house.
4. Research the Project – Private activity bonds are for the benefit of a private corporation, not a government funded agency.  Just as you research companies for stock investing, be sure to know the extensive financial history of the company benefiting from the bond and whether their financial projections will help them complete the public project assigned to them.

The issuance of private activity bonds dropped a dramatic 52% from 2007 to 2008.  It is obvious that economic indicators are a big influence on how and to whom private activity bonds are issued.  If you are interested in allocating a portion of your portfolio to private activity bonds, be sure to perform extensive research in order to assure that your money will be in a safe place.

Most tax free municipal bonds are issued by a government entity who wants to encourage financial investment in community.  Your investment dollars in tax free municipal bonds go toward building roads, sewers, and other infrastructure projects.  The goal of a tax free municipal bond is to generate income and pay tax exempt dividends to investors.  Tax free municipal bonds permit interest yield to be free of federal tax – and sometimes state and local tax as well. 

What Qualifies a Tax Exempt Municipal Bond?

Not all municipal bonds are tax free or tax exempt.  In most cases, tax free municipal bonds are strictly geared towards public works, where investment dollars go toward projects to improve public infrastructure.  These tax free municipal bonds are also called general obligation bonds.

However, the type of project for which a municipal bond is issued can affect the tax status of the bond.  A revenue bond is a municipal bond issued to benefit private for-profit activity, such as a baseball stadium or an airport.  These types of revenue bonds may be subject to the federal alternative minimum tax.

How Can You Benefit from Tax Free Municipal Bonds?

You can benefit from a tax free municipal bond depending on your tax status.  Though tax free municipal bonds do provide all investors with tax exempt status on dividends and interest, not all investors will enjoy the potential yield. 

For instance, an investor in a higher tax bracket, say 33%, can most likely enjoy a better interest return on a tax free municipal bond than a corporate bond with a similar interest rate.  By contrast, a lower tax bracket investor, say in the 15% range, will not reap as much interest yield with a tax free municipal bond than a corporate bond of the same rate.  It is always recommended that you check with an investment broker to determine whether a tax free municipal bond investment is right for you.

Remember that tax free municipal bonds may also be tax exempt from state and local taxes.  When investing in tax free municipal bonds, keep in mind the potential state tax burden that can be saved as well. 

The tax exemption status of tax free municipal bonds offers a great way for some investors to protect their investment income from double taxation at the federal and state level.  Check with your investment broker about how you can allocate part of your portfolio wealth in these tax havens.

Of course, a municipal bond investment is not a way to generate annual double digit returns, but they are a key part of a sound, diversified investment strategy. 

 What are Municipal Bonds?

Municipal bonds are a debt instrument issued by government agencies, such as cities, counties, or state governments. If you are investing in municipal bonds, they typically fall under one of two categories:

• General Obligation Bonds (GO Bonds) – These bonds are backed by the ability of the issuing agency to tax its constituents.  GO Bonds are mainly used to help finance public works, such as new sewers, new roads, or even a new baseball stadium. 
• Revenue Bonds – Revenue bonds are issued by governing agencies to raise money or create revenue for sanctioned entities, such as hospitals or public zoos.  These bonds help build infrastructure and are also backed by the taxability of the issuing government.

 What Do Municipal Bond Investments Offer as an Investment Strategy?

When you consider municipal bond investment, there are a number of other factors to evaluate, including tax advantages, income stream desires, and interest yield.  Of course, a high-interest yield bond is usually the most desirable, and you also want to opt for a muni with a high yield and good credit rating. 

Municipal bond investment may offer a yield at maturity or stream of income option, depending on the issuing agency.  In many cases, bond issuers will make regular interest payments on a muni, providing you with a nice stream of income.  However, others may wait to pay the full interest yield at maturity. 

Municipal bond investment also requires you to consider the tax advantages.  Municipal bonds may be issued as a tax-free or a taxable instrument.  Depending on your income bracket, you can save money on taxes with municipal bond investment.  Check with your financial advisor for which is best for you. 

Investing Municipal Bonds: Risk Factors

Investing in municipal bonds doesn’t come without financial risk.  Each government bond is rated by a professional rating agency, such as Standard & Poor’s or Moody’s.  The rating agency will research the financial strength of the issuing government to repay a bond, as well as the strength of the local economics.  A muni issued by a thriving and growing community will have a much better rating than one from a city in economic decline and high unemployment. 

To be as safe as possible with your municipal bond investment, consider investing in a government that has a good history of bond repayment, has a growing population, and a diverse economy.

Municipal bond investment is a practiced and low-risk investment strategy.  Though yields are not the best compared to all of your financial instrument options, you can generate a good and secure stream of income from municipal bond investment, as well as enjoy tax advantages from government issued bonds.  However, always be sure to check the credit rating of the government bond before investing to ensure that you have a low-risk option.

Municipal bonds are debt instruments issued by government agencies, such as cities or counties, with the intention of raising capital and funds for public works.  Allocating a certain percentage of your wealth in this type of low risk bond is smart advice; however, even a low-risk investment does have an element of risk. 

 What are Insured Municipal Bonds?

Not all municipal bonds are created equal.  For investors who want the safest and securest investment, insured municipal bonds offer guaranteed protection and returns.  If the government agency who issues a bond defaults on the bond and is unable to make scheduled interest payments, the insurer will step in and pay the guaranteed interest rate.  The good news is that investors do not pay any more for the insured municipal bond since the premium is paid by the issuer.

Why Invest in Insured Municipal Bonds?

When you invest part of your wealth in insured municipal bonds, you are ensuring that your funds remain safe.  With the added assurances and the unconditional guarantee of the insurer, you can rest assured that your money will grow at a guaranteed pace.  Although insured municipal bonds are not the highest interest or yield investment, where else can you get a guarantee for your money? 

 There are many other benefits associated with investing in insured municipal bonds aside from the guaranteed interest and principal payments.  Most insured municipal bonds are also tax-free, as the government wants to encourage investors to put their money in municipal projects.  And by doing so, you can enjoy an interest yield that is free from federal tax burdens.  Some insured municipal bonds also come with state tax advantages as well.

 Insured Municipal Bonds vs. Regular Bonds

Though bonds in general are a safer investment vehicle than equities, they still come with certain risks, and an investor could lose money if a bond issuer fails to remain solvent and make scheduled interest payments.

However, an insured municipal bond comes with the highest rating from the major rating agencies.  Insured municipal bonds are very low risk and conservative for any investor.  Additionally, the low risk and insured aspect makes an insured municipal bond more liquid than most bonds on the market.  This can be especially pleasing to investors who want to remain liquid in a volatile economic and investment market.

 Additionally, insured municipal bonds offer a higher yield than other non-insured municipal bonds.  Since the insured municipal bond comes with a higher rating are scrutinized more, the yield is generally a little better.

 Where to Buy Insured Municipal Bonds

If you have decided to invest in the safe yield of insured municipal bonds, most brokerage houses deal with these types of instruments.  Contact your investment broker to find out how to add the right insured municipal bonds to your portfolio.

 What are High Yield Municipal Bonds?

 Municipal bonds, or “munis,” are debt instruments issued by a municipality, such as a city or county for the purposes of public works.  Your sewers, streets, are bridges are in part funded from capital raised from the issuance of municipal bonds. 

 Municipal bonds are usually a good investment because they are most often conservatively rated at A or better by the three major rating agencies.  Traditionally, the trade off for a low risk municipal bond is the lower interest rate.  However, there exists a brand of municipal bond yields that are higher than the average and still provides a relatively conservative low risk rating. 

 Municipal bond yields at higher interest rates are offered by many states and larger cities.  These types of high yield municipal bonds offer higher interest rates in exchange for a higher risk.  Although the risk is higher, the default rate on high yield municipal bonds is still lower than corporate high yield bonds. 

 Advantages of Buying High Yield Municipal Bonds

For the average investor who wants to allocate a portion of his or her wealth into low risk bonds, buying high yield municipal bonds offer a spectrum of benefits and advantages.  Here are just a few:

• More Interest – Buying high interest municipal bonds gives an investor a safer way to make more money.  Though yields are not exceptional compared to prudent stock or real estate investing, municipal bond yields can still provide a sure way to make a reasonable rate of return on invested wealth.
• Tax Free Income – Buying high yield municipal bonds can also offer an added advantage of tax exemption.  Most general obligation municipal bonds are issued with tax free status, meaning that all dividends and interest earned is free from federal tax, and in many cases, exempt from state tax as well.
• Low Default rates – Buying high yield municipal bonds are riskier than normal municipal bonds, but still safer than many corporate high yield bonds.

Risks of Buying High Yield Municipal Bonds

Risk still exists for any type of uninsured investment.  Below are a few risks you may encounter from buying high yield municipal bonds:

• Higher default than regular municipal bonds – With higher interest comes a higher default rate.  Generally, high yield municipal bonds are backed by the assets and income produced from public projects, such as toll bridges, but default rates of 8% to 44% are not uncommon for lower rated bonds.
• Rates may fluctuate – Governments have cash flow problems too.  Sometimes a project is cancelled in the middle of construction, making the value of a bond specific to that project to drop on the secondary market. 
• Lower yield than corporate bonds – Though buying high yield municipal bonds can bring in higher income than regular munis, corporate high yield bonds still have an even higher interest average.

 Always speak with a financial advisor before buying a high yield municipal bond.  However, with prudent research and strategy, a municipal bond yield may be a good choice for portfolio allocation.

A bond is an investment instrument providing the investor with a pre-determined rate of return and duration.  Usually investors will find both short term (3 years or less) and longer term (up to 20 years) bonds with a fixed interest rate.  However, it is not uncommon for bonds to be sold from investor to investor during the term of a bond.  And because current market interest rates are flexible and change frequently, bond convexity calculation is required to help address the changes in price of a bond on the secondary market.

 What Is Bond Convexity?

Bond convexity is a helpful calculation tool to compare two or more different bonds, their current rate of return, and their market risk.  Fluctuations in market interest rates have a tremendous impact on bond convexity.  A bond with a coupon rate, or a pre-determined schedule of dividend payments, can sell for a higher or lower price depending on the current market interest rate.  A bond with a higher coupon rate selling in a market with lower interest will attract a higher price from another investor.  Conversely, a lower coupon rate in a market of higher interest rates will provide a reduced yield, and thus, will sell for a lower price.  Generally, the higher the coupon rate is, the lower the convexity the bond will be.  Zero coupon bonds with only one interest payment at maturity have the highest convexity. 

 How is Bond Convexity Calculated?

Consider a matrix where the x-axis is price, while the y-axis is yield.  Considering all factors remained the same, you would predict that a straight diagonal line represents a convexity tangent.  A higher price results in a corresponding lower yield. 

However, market conditions are not always the same.  Consider that the bond convexity tangent is a bowl shape (convex).  The higher the convexity, the deeper the bowl will be.  Therefore, the actual bond price changes within the yellow area of the illustration below based on current market interest rates and the duration of the bond.

For example, you are in the market to purchase either Bond I or Bond II.  Both have the same interest rate and duration.  Bond I is has a higher credibility rating from Moody’s, while Bond II is a zero coupon bond.  A higher rating means there is less risk for Bond I, thus it has a smaller convexity.  Bond II has a higher convexity since it provides a set yield at maturity, thus it is more susceptible to market fluctuations.  By comparing the bond convexities, you can determine as an investor which risk you would rather take with your purchase.

Bond convexity is not for the faint of heart.  It is a complex calculation which can be found using online calculators or pre-programmed Excel functions.  However, with bond convexity aids, you have the tools needed to determine the right bond for your investment needs.

Bond convexity is a direct measure of the duration sensitivity of a bond when its interest rate is changing. There is one key thing to remember here, as bond yields go higher, the price of them goes lower. In essence, the relationship this statement has, between price and yield, it has a convex structure in nature. You won’t be surprised to hear that this relationship is otherwise known as convexity. For any type of bond, a graph of the direct relationship between its price and yield is convex. As we have already mentioned, this means the graph forms a curve rather than a straight-line which would be called linear. Just how curved a graph is shows how much a bond’s yield changes in response to changes in price.

What is the bond convexity calculation?

As we have already discussed, convexity is a direct measure of the curvature or 2nd derivative of how the price of a bond varies with a specific interest rate. In more simplistic terms, this means how the duration of a bond changes as the interest rate also changes. We will assume in this example that the interest rate of the bond does not change or at least for the life of the bond, it remains static. A duration can therefore be formulated as the first derivative of the price of the bond. Using convexity methods, the 2nd derivative can be used with the interest rate.

What are the factors that affect bond convexity?

• Callable bonds negate convexity at particular price-yield combinations (ie; As market yields decrease so to does duration).
• The higher the coupon rate the lower the convexity of a bond (Zero-coupon bonds are the bonds with the highest convexity).
• Price yield relationship shows us that price-yield curve will increase as yield decreases. (ie; As market yields decrease the duration increases).

What is the bond convexity formula?

We attempted to produce a guide explaining the bond convexity formula but we just couldn’t do it justice and would recommend you see the contribution at Wikipedia which you can find here.

There are two major differences between private bonds and public bonds; first, the facility will be privately owned, and second, private bonds are taxed unless otherwise stated. According to The Tax Reform Act of 1986 where municipal bonds were separated into two types; public purpose bonds and private purpose bonds – Public purpose bonds are exempt from federal taxation. Private purpose bonds however as already stated are taxed.

Private bonds can be used to construct facilities that will be used by the public, and this is one of the main uses of private bonds. Private bonds interest is payable on all investments taken out, the amount of payable interest however depends on the terms of the agreement.