Tax-exempt bonds

Definition

Tax-exempt bonds are securities issued by government entities or nonprofit organizations that pay interest which is exempt from federal income tax, and sometimes state and local taxes. This makes them an attractive option for investors seeking to minimize their tax liabilities while earning a stable income. The exemption enhances the appeal of these bonds compared to taxable bonds, impacting their issuance, valuation, and amortization.

5 Must Know Facts For Your Next Test

1. Tax-exempt bonds are typically issued by state and local governments to finance public projects like schools, highways, and hospitals.
2. The interest income from tax-exempt bonds is not subject to federal income tax, and in some cases, it may also be exempt from state and local taxes for residents of the issuing state.
3. Due to their tax advantages, tax-exempt bonds generally have lower interest rates than comparable taxable bonds, which can influence their overall valuation.
4. Investors in higher tax brackets benefit more from tax-exempt bonds because the tax savings can significantly enhance their effective yield compared to taxable alternatives.
5. Amortization of premium or discount on tax-exempt bonds must be accounted for, as it can affect the reported interest expense and the actual yield realized by investors.

Review Questions

• How do tax-exempt bonds compare to taxable bonds in terms of investor appeal and valuation?
  • Tax-exempt bonds are generally more appealing to investors in higher tax brackets because the interest income is exempt from federal income tax, potentially offering a higher effective yield than taxable bonds with similar risk profiles. This tax advantage can lead to a lower interest rate for issuers since investors are willing to accept less return in exchange for the tax benefits. As a result, the valuation of tax-exempt bonds may reflect these dynamics, often resulting in them trading at a premium or a favorable price compared to taxable options.
• Discuss the implications of interest rate risk on the valuation of tax-exempt bonds.
  • Interest rate risk significantly affects the valuation of tax-exempt bonds because when market interest rates rise, the prices of existing bonds tend to fall. This relationship can be more pronounced for long-term tax-exempt bonds due to their longer duration. Investors must consider this risk when investing in these securities, as changes in rates can impact their market value and overall return. In an environment of rising rates, tax-exempt bonds may lose value faster than their taxable counterparts if investors reassess the yield in light of new market conditions.
• Evaluate how changes in bond ratings can affect the attractiveness and pricing of tax-exempt bonds in the market.
  • Changes in bond ratings can have a significant impact on the attractiveness and pricing of tax-exempt bonds. An upgrade in rating indicates improved creditworthiness, often leading to increased demand and higher prices for those bonds as investors seek lower-risk assets. Conversely, a downgrade may signal potential financial distress for the issuer, causing prices to drop as investors demand higher yields to compensate for increased risk. This dynamic highlights how credit ratings directly influence investor perceptions and market behavior towards tax-exempt securities.

Related terms

Municipal Bonds: Debt securities issued by states, municipalities, or counties to finance public projects, often offering tax-exempt interest payments.

Interest Rate Risk: The risk that changes in market interest rates will affect the value of a bond, influencing its valuation and attractiveness to investors.

Bond Rating: An assessment of the creditworthiness of a bond issuer, which affects the bond's interest rate and market value.