Municipal Bonds and their rules - regulations are covered quite heavily on the Series 7 Exam. Some of these question deal with the core understanding of Muni Bonds and their advantages. The main quality behind these bonds is their tax free status with regards to interest income. Nothing is exempt from Capital Gains Profit (a trick question sometimes on the Test)
Since Municipal Bonds (large majority of them) are exempt from Federal Tax on the interest received, they do not have to offer high coupon interest rates. This allows States and Local Municipalities to raise capital on borrowed money through a bond issue at a lower cost.
Since many Muni Bonds are backed by taxes (G.O - General Obligation Bonds), this is a benefit to the people who live within that municipality.
Tax Equivalent Yield
This is the yield (not the coupon rate always) that a taxable investment like a corporate bond would have to beat to "out-do" a Muni Bond. This assumes ratings and maturity are fairly equal between the 2.
The formula is:
taxable yield = tax free yield divided by 100-tax bracket
If a Muni Bond had a 3% coupon rate and an investor was in the 28% tax bracket and is also being offered a 4.5% corporate bond, which bond would offer the best yield given the tax advantage of the Municipal.
The Muni in this example is 3%. So 3 divided by 72 (100-28) = 4.16%
That 4.16% is what a taxable investment would have to be better than for the investor to not buy the Muni issue. Again, there will be other factors at play, but strictly speaking YIELD, the Corporate at 4.5% would be better - even though it is a taxable investment.
Free Online Glossary from American Investment Training
Series 65 Note
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