PrivateBonds.com

A private purpose bond is one of the two types of municipal bond separated by The Tax Reform Act of 1986. The other type of municipal bond is a public purpose bond which differs quite considerably to the former.

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.

A municipal bond fund is essentially a mutual fund investment in a municipal bond (i.e. “munis”). As we have already covered, municipal bonds are debt securities issued by a municipality, country or state to fund its capital expenditures.

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.

A mortgage bond, as one would assume, is a bond that is directly secured by a mortgage on one or more physical/tangible assets. Mortgage bonds are usually secured by real estate and/or property associated with real estate holdings.

Typically speaking, mortgage backed bonds offer exclusive protection that is rarely offered by other similar bonds. They offer the investor a massive amount of collateral in the form of protection as the asset could potentially be sold off to cover any debt that is owed. However, with this extremely good rate of protection comes the major drawback, these sorts of bonds have fairly low rates of yield, especially when compared to the more traditional corporate bonds and private bonds that are only backed by the corporation’s or municipality’s promise and real time ability to return payments.

A mortgage revenue bond is where the investment is in part subsidised by the government or authoritative entity that supports a certain demographic of low income earners to allow them to make home purchases. This type of bond was most popular in the late 80’s and early turn of this decade when borrowers were faced with an inability to purchase houses due to the depressive state of the US economy.

A revenue bond as its rather apt name would suggest is a type of municipal bond that is specifically guaranteed for repayment through revenues generated solely by an entity or source of revenue directly associated with the purpose of the bond. The revenue stipulated in the legal contract established between the bond holder and issuer is the source of repayment of the principal and interest of the bonds. This comparatively speaking is different from general obligation bonds where a state or local government pledges to use legal sources such as tax revenues to repay bond holders. In addition, the security of the pledge is not as secured as general obligation bonds; however the interest rate of revenue bonds will see higher interest rates.

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.

An official definition would lead us to say that taxable bonds are debt securities whose return to the investors are subject to certain taxes, such as local, state or federal. The vast majority of bonds that are issued are subject to taxes and are therefore applicable as taxable bonds. In the past, when traditional issuers offered tax-free bonds for certain projects are now most commonly issued with interest taxable bonds unless the project benefits the public at an increased level.

Taxable municipal bonds most commonly pay a higher rate of interest than other bonds, however with protection from early redemption and some exemption from state and/or local taxes with which the bonds are issued, it evens itself out. States will usually always use their allotted quantity/value of tax-exempt bonds and therefore issue taxable bonds which are most commonly used to finance private development. Taxable municipal bonds are always issued as private purpose bonds when financing projects such as sports entertainment facilities.

In essence, the risk of a municipal bond is directly measured by how likely the issuer is to complete all agreed payments in a timely and complete manner. The agreement that was made between the municipal bond issuer and the bond holder defines the specifications of the deal from what quantity of payments must be made, when they are to be made, to whom and how they are to be paid. Each agreement is different and the specifications of a municipal bond agreement are unique and of course confidential to those parties whom it concerns.

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.

Municipal bonds tax rates are considerably different from the typical setup and tax liabilities of other types of investment bonds. The most important aspect of the municipal bond tax band is that they are considered entirely separate from other bonds because they have the ability to offer tax-exempt income from their investments.

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.

Municipal bond issuers are those organisations in charge of distributing bonds in exchange usually for a cash payment. Municipal bonds are issued normally by countries, states and cities within those municipality. You also see agents who act on behalf of those whom the bond directly belongs to. The law governing the issue of municipal bonds is highly extensive and full of numerous barriers to entry for those who are not compatible with them. It should be mentioned that these laws and the legislation that they represent vary country by country, state by state. The interest rate that municipal bonds receive is either a fixed or variable sum, depending again on the terms laid out by the issuer.

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.