Taxable Municipal Bond Definition

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Taxable Municipal Bond Definition

What Is a Taxable Municipal Bond?

A taxable municipal bond is a non-tax-exempt fixed-income security issued by a local government, such as a city, county, or comparable organization, to fund projects that will not be subsidized by the federal government.

Key Takeaways

  • A taxable municipal bond is a fixed-income security issued by a local government, such as a city, county, or comparable organization, to fund projects that will not be subsidized by the federal government.
  • Taxable municipal bonds are often used to finance initiatives that do not benefit the general public directly, which is why they are not tax-exempt.
  • Taxable municipal bonds are primarily issued to address state and local pension fund deficits.

Understanding Taxable Municipal Bonds

Taxable municipal bonds are often issued to fund an activity that is not seen to deliver a significant benefit to the public. This indicates that the federal government will not award these projects tax exemption status.

The fact that most municipal bonds are tax-exempt is a key aspect. A municipal bond is a bond issued by local and state governments to support community improvement initiatives such as the construction of schools, roadways, and hospitals. A municipality may also issue a bond on behalf of a private enterprise that would otherwise be unable to get project finance.

These private activity bonds (PABs) attract private firms, resulting in greater employment opportunities in the region. An investor who purchases a municipal bond is giving money to a municipality, which agrees to pay interest on a regular basis until the bond matures, at which time the investor’s primary investment is refunded.

Municipal bonds are free from federal taxes and certain state taxes, depending on the scenario and particular state regulations, to encourage investors to acquire them. Municipal bonds, on the other hand, are only tax-exempt if the initiatives financed with the proceeds of the issuance benefit the community as a whole—in other words, the public.

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While many investors will prefer municipal bonds for the tax advantage despite the lower return, depending on the individual’s current tax band, there may be taxable bonds available that give a greater after-tax yield.

Types of Taxable Municipal Bonds

The vast majority of taxable municipal bonds are issued to cover state and local pension fund deficits. Other uses for taxable municipal bonds include financing local sports facilities, supporting infrastructure-related repairs or investor-led housing, and debt refinancing.

Build America Bonds (BABs) are taxable municipal bonds. BABs were established under the American Recovery and Reinvestment Act (ARRA) of 2009 and, although taxable, provide specific tax credits and government subsidies to either the bond issuer or the bond holder. Taxable municipal bonds are popular among institutional investors and mutual funds that are unable to benefit from other tax benefits.

Requirements for Taxable Municipal Bonds

Because the federal government would not fund the financing of these projects, interest on municipal bonds issued to finance initiatives with no evident public benefits is taxed. Taxable municipal bonds give risk-adjusted yields equivalent to those available from other taxable entities, such as corporate bonds and other government agency bonds, since income from such bonds is taxable in the investor’s hands. The dangers and advantages of each strategy will differ based on a variety of personal characteristics.

Some taxable municipal bond offerings are exempt from state and, in some cases, local taxes, in which case investors who live in the state of issuance are not taxed on their interest profits. As a result, the effective yield on the bond will be greater than the advertised rate.

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