As investors contend with low yields and the possibility of higher taxes, investments that are tax-free have particular appeal. Despite some recent high-profile defaults, municipal bonds have an exemplary track record of safety, and bonds issued within the state of South Carolina offer returns that are free from both federal and state taxes. Let’s look at some basic background on these investments, as well as a few tips on getting started.
The state of South Carolina, as well as our cities, counties, and improvement and utility districts, all issue bonds to finance operations, capital expenditures, and development. These bonds have a stated interest rate and a promise of repayment at a specific time in the future, known as the maturity date. The safety of these bonds, both investment income and principal, is determined by the source of the funds designated for repayment. The two major categories of Municipal bonds are general obligation, or G.O. bonds, and revenue bonds. General obligation bonds are backed by the taxing power of the issuer, which could mean income taxes, in the case of state of South Carolina, or property taxes, for bonds issued by a county. Revenue bonds, on the other hand, are backed by revenue from the particular project for which the bonds are issued. For example, bonds issued to pay for the Cross Island Expressway would be backed and repaid by toll revenue from drivers who use the expressway.
Ratings and Safety
Two rating agencies, Standard & Poor’s and Moody’s, do most of the rating of municipal bonds, and perform credit analysis, income projections, and provide investors with a letter grade that gives some framework for evaluating the safety and security of a bond. Bond issuers can pay to have their bonds rated, which can make them easier to sell to investors unfamiliar with a particular project or municipality. Standard & Poor’s ratings for municipal bonds range from the highest, AAA, meaning an “extremely strong capacity to meet financial commitments,” through AA, A, BBB, all the way down to D, signifying a bond in default. In the past, bond issuers with sufficient credit could also purchase insurance from private bond insurers. These insurers would guarantee the repayment of principal and interest using their credit rating; accordingly, most insured bonds would be given AAA rating. However, in the turmoil of the 2008 recession almost all bond insurers lost some of their sterling credit standing; as a result, the bonds they insured reverted to their underlying ratings.
Calculating the taxable equivalent yield
In order to determine if a tax-free bond makes sense for you, you will need to compare it with a taxable investment. Let’s take as an example a AA rated General Obligation unlimited tax revenue bond issued by Charleston County, maturing in 12 years, paying interest twice a year, which has a yield of 2.24 percent. You are in a combined federal and state tax bracket of 30 percent. First, subtract your tax rate expressed as a percentage (.30) from 1. So, 1.00-.30=.70. Then, divide the yield on the bond (2.24 percent) by .70 to determine the taxable equivalent yield, which is 3.2 percent. You would have to get a 3.2 percent rate of return on a taxable investment to equal the after-tax return on your 2.24 percent tax-free bond.
Par value, Calls, and Prices
Par value, and in most cases maturity and face value, of a municipal bond is $1,000. Municipal bond prices are not stated as a dollar price, but as a percentage of par value. A price of 98 would signify 98 percent of $1,000 of par value, or a dollar price of $980. A price of 113 would signify 113 percent of par, or a dollar price of $1,130. Par, or 100, would mean a price of $1,000 per bond. Bonds priced above par are known as premium bonds; bonds priced below par are called discount bonds. Some bonds are callable, meaning that the issuer can redeem the bond early, at par value, or a price slightly above par. If the bond is purchased at a discount or at par, you should evaluate the bond for its “yield to maturity.” If the bond is purchased at a premium and can be called, the relevant figure is the “yield to call,” typically lower than the yield to maturity.
How to get started
Most bonds are generally held in a brokerage account, so if you don’t already have an account you’ll need to set one up. A good discount or full-service broker will typically have an inventory of South Carolina bonds, and an advisor can assist you in identifying a bond with a rating and maturity that fit your requirements. Sometimes the original offering statement and credit report of the bond is available; if so, you can ask for a copy to review. Municipal bonds are most frequently sold in increments of $5,000; many bond professionals, though, recommend a mutual fund if you are not able to purchase at least $25,000 per issue. Your bond will be priced on each monthly brokerage statement, which can give you an indication of the current selling price, should you want to sell before maturity.
In South Carolina, the Santee Cooper Electric Cooperative offers bonds from time to time directly to the general public through a subscription, and these bonds are available in smaller increments, called mini-bonds. Interest rates on their next bond series will be announced Oct. 1, 2012, and you can subscribe to these bonds from Oct. 1 through Oct. 31, 2012. Additional information is available from their website www.santeecooper.com, under FAQs.
Steven Weber is the senior investment advisor for The Bedminster Group, a Registered Investment Advisor providing portfolio management, estate, and financial planning services. The information contained herein was obtained from sources considered reliable. Their accuracy cannot be guaranteed. The opinions expressed are solely those of the authors and do not necessarily reflect those from any other source.