Private Client Group

Understanding Yields

There are basically two types of bond yields you should know about: current yield and yield to maturity. Current yield is the annual return on the dollar amount paid for a bond. Yield to maturity is the total return you receive by holding a bond until it matures. It equals the interest you receive from the time you purchase the bond until maturity, plus any gain (if you purchased the bond below its par or face value) or loss (if you purchased it above its par value).
 
Tax-exempt bond yields are usually stated in terms of yield to maturity, with yield expressed at an annual rate. If you purchase a bond with a 6% coupon at par, its yield to maturity is 6%. If you pay more than par, the yield to maturity will be lower than the coupon rate. If purchased below par, the bond will have a yield to maturity higher than the coupon rate. When the price of a tax-exempt security - or any bond for that matter - increases above its par value, it is said to be selling at a premium. When the security falls below par value, it is said to be selling at a discount.

How Safe are Municipal Bonds?

When you invest in any bond, your primary concern should be the issuer's ability to meet its financial obligations. Issuers of municipal bonds have an outstanding record of meeting interest and principal payments in a timely manner.
 
Issuers disclose details of their financial condition through "official statements" or "offering circulars" which are available from your bank, brokerage firm or from a library of official statements.
 
Another way to evaluate an issuer is to examine its credit rating. Many bonds are graded by rating agencies such as Moody's Investors Service, Standard & Poor's Corporation and Fitch Investors Service, Inc. A number of banks and brokerage firms have their own research departments which also analyze municipal securities. Bond ratings are important benchmarks because they reflect a professional assessment of the issuer's ability to repay the bond's face value at maturity. Generally, bonds rated BBB or Baa, or better, by Standard & Poor's and Fitch, or Moody's, respectively, are considered "Investment Grade," suitable for preservation of investment capital.

Credit Ratings

Understanding Market Risk

While the interest payment, also known as the coupon rate, cannot be changed during the life of a bond (unless, of course, it is a variable-rate security), the market price of a security changes as market conditions change. If you sell your municipal bonds prior to maturity, you will receive the current market price, which may be more or less than their original price. Consequently it is important to understand how the direction of interest rates might affect the value of your holdings. As with other fixed-income securities, municipal bond prices fluctuate in response to changing interest rates: prices increase when interest rates decline, and prices decline when interest rates rise. It is easy to understand the reasons:

• When interest rates fall, new issues come to market with lower yields than older securities, making the older securities worth more; hence the increase in price.
• When interest rates rise, new issues come to market with higher yields than older securities, making the older ones worth not as much; hence the decline in price.

Understanding Calls

Many bond issues allow the issuer to call or retire all or a portion of the bonds at a premium, or at par, before maturity. When buying bonds, be sure to ask your dealer about call provisions. Dealers will typically quote the yield to call and the yield to maturity when the yield to call is lower. This will generally occur when the bonds are trading at a price above the initial call price.

Gains and Losses

You may generate capital gains on a tax-exempt security if you sell it at a profit in the secondary market before it matures. Long-term capital gains resulting from the sale of tax-exempt municipal bonds (or from holding them to maturity) are taxed at a maximum rate of 28%.

Of course, if you sell your security for less than your original purchase price, you may incur a capital loss. Under current law, up to $3,000 of net capital losses can be used annually to reduce ordinary income. Capital losses can be used without limit to reduce capital gains. Special rules apply to a tax-exempt bond purchased at a premium or a discount and called or sold before maturity. (Since tax laws frequently change, consult with your tax lawyer or accountant for up to date advice.)

Bonds with Special Investment Features

Insured municipal bonds - Many municipal bonds are backed by municipal bond insurance specifically designed to reduce investment risk. In the unlikely event of default, an insurance company which guarantees payment will send you both interest and principal when they are due.

Floating rate and variable rate bonds - These securities are attractive in a rising interest rate environment. Generally, interest is periodically re-calculated based upon a percentage of prevailing rates for Treasury bills or other interest rates.

Zero coupon, compound interest and multiplier bonds - These securities are issued at a deep discount of the maturity value and have no periodic interest payments. You receive one lump payment at maturity equal to principal invested, plus interest compounded semiannually at the original interest rate. Because they do not pay interest until maturity, their prices tend to be volatile. These bonds are especially attractive if you seek to accumulate capital for a long-term financial goal such as retirement planning or college costs.

Put bonds - Some bonds have a "put" feature which allows you to redeem the bond at par value on a specified date, long before its maturity date. If interest rates increase, you can cash in the bonds at any put date, recoup the principal and purchase higher-yielding bonds.

Types of Tax-Exempt Municipal Bonds

Municipal securities consist of both short and long-term issues. Short-term securities, often called notes, typically mature in a year or less, while long-term securities, commonly known as bonds, typically mature in more than a year. Short-term notes are used by an issuer to raise money in anticipation of future revenues such as taxes, state or federal aid payments and bond proceeds, and to cover irregular cash flows, meet unanticipated deficits and raise immediate capital for projects until long-term financing can be arranged. Bonds are usually sold to finance capital projects over the longer term. The basic types of municipal securities are:

General obligation bonds - Principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer's unlimited or limited taxing power. General obligation bonds are also voter-approved.