security whose interest is not subject to federal or local tax in the state of the issuer. Though often called a municipal bond, it may also be issued by a county, state, or state agency. For example, a New York City resident does not pay federal, state, or city tax on the interest received from a New York City obligation. It is triple tax-free, though this is not necessarily true of other states. An investor in a mutual fund that invests solely in tax-exempt bonds often pays no tax on interest earned. However, some states tax fund dividends. The return on a tax-exempt bond is equivalent to a higher return on a taxable corporate bond because of the tax savings. The dollar advantage of a tax-exempt security increases as the tax rate rises. Assume a taxpayer in the 35% tax bracket receives 6% on a taxexempt bond. The equivalent taxable yield on a corporate bond is 9.23% (6%/.65). It should be noted, however, that the holder of a taxexempt security does have to pay tax on the gain at the time of sale representing the difference between the cost and the selling price. For example: An investor buys a $1000, 5% tax-exempt bond for 90%. The cost is therefore $900. The taxpayer will be taxed on the gain of $100 in the year the bond is redeemed.

obligation whose interest is exempt from taxation by federal, state, and/or local authorities. It is frequently called a municipal bond

(or simply a municipal), even though it may have been issued by a state government or agency or by a county, town, or other political district or subdivision. The security is backed by the full faith and credit or by anticipated revenues of the issuing authority. Interest income from tax-exempt municipals is free from federal income taxation as well as from taxation in the jurisdiction where the securities have been issued. Thus, New York City obligations are triple tax exempt to city residents whose income is taxed on the federal, state, and local levels. (A very few municipalities tax residents for their own otherwise tax-exempt issues.)

mutual funds that invest exclusively in tax-exempt securities confer the same tax advantages on their shareholders. However, while a fund's dividends would be entirely tax-exempt on a shareholder's federal tax return, they would be free from state income tax only in proportion to the amount of interest income derived from the taxpayer's home state, assuming no interstate reciprocity arrangements pertain.

The return to investors from a tax-exempt bond is less than that from a corporate bond, because the tax exemption provides extra compensation; the higher the tax bracket of the investor, the more attractive the tax-free alternative becomes. Municipal bond yields vary according to local economic factors, the issuer's perceived ability to repay, and the security's quality rating assigned by one of the bondrating agencies.

municipal bond that is repaid from taxes imposed on those who benefit directly from the neighborhoodoriented public works project funded by the bond; also called special assessment limited liability bond, special district bond, special purpose bond, special tax bond. For example, if a bond finances the construction of a sewer system, the homeowners and businesses hooked up to the sewer system pay a special levy that goes to repay the bonds. The interest from special assessment bonds is tax free to resident bondholders. These are not normally general obligation bonds, and the full faith and credit of the municipality is not usually behind them. Where the full faith and credit does back such bonds, they are called general obligation special assessment bonds.

municipal bond backed by the full faith of the issuing government but not by its full taxing power; rather it is secured by the pledge of a special tax or group of taxes, or a limited portion of the real estate tax.

bond issued by a municipal or state agency to finance construction of a hospital or nursing home. The latter is then operated under lease by a not-for-profit organization or a for-profit corporation such as Columbia/ HCA. Ahospital revenue bond, which is a variation on the Industrial Development Bond, is tax exempt, but there may be limits to the exemption.

Unit Investment Trust that buys municipal bonds and passes the tax-free income on to shareholders. Bonds in the trust's portfolio are normally held until maturity, unlike the constant trading of bonds in an open-ended municipal bond fund's portfolio. MITs are sold through brokers, typically for a sales charge of about 3% of the principal paid, with a minimum investment of $1000. The trust offers diversification, professional management of the portfolio, and monthly interest, compared with the semiannual payments made by individual municipal bonds.

Many MITs invest in the securities of just one state. For California residents who buy a California-only MIT, for example, all the interest is free of federal, state, and local taxes. In contrast, a Californian who buys a national MIT might have to pay state and local taxes on interest derived from out-of-state bonds in the trust's portfolio. Also called Municipal Bond Unit Trust.

taxable debt obligation of a state or local government entity, an outgrowth of the tax reform act of 1976 (which restricted the issuance of traditional tax-exempt securities. Taxable municipal bonds are issued as private purpose bond to finance such prohibited projects as a sports stadium; as municipal revenue bonds where caps apply; or as public purpose bonds where the 10% private use limitation has been exceeded.

Government securities: exchange of maturing government securities prior to their due date for issues with a later maturity. It is through advance refunding that the national debt is extended as an alternative to the economic disruptions that would result from eliminating the debt all at once.
Municipal bonds: sale of new bonds (the refunding issue) in advance, usually by some years, of the first call date of the old bonds (the issue to be refunded). The refunding issue would normally have a lower rate than the issue to be refunded, and the proceeds would be invested, usually in government securities, until the higher-rate bonds become callable. This practice, also called prerefunding, has been curtailed by several tax acts. See also Refunding Escrow Deposits (REDS).

municipal bond financing practice whereby underwriters in advance refunding (prerefunding) slap excessive markups on U.S. Treasury bonds bought and held in escrow to compensate investors during the time between issuance of the new bonds and repayment of the old ones. Since bond prices and yields move in opposite directions, when underwriters mark up the bonds, they "burn down" the yield, violating federal tax rules and costing the government tax revenues. Under IRS regulations, municipalities, not the underwriters, incur the tax liability. The SEC, which was conducting a wideranging probe of alleged yield-burning abuses by Wall Street firms in the late 1990s, favors making the underwriters responsible, not the municipalities.

debt issued by a municipality to finance plants and facilities that are then leased to private industrial businesses; also called industrial revenue bond. The subsequent lease payments are used to service the bonds. The intent of IDBs is to attract private industry to promote local economic development. IDBs appealed to investors because they were exempt from federal income taxes. Exemption for IDBs is being phased out. A new category of tax-exempt bonds, called qualified redevelopment bonds, is to be used to finance land acquisition and redevelopment in blighted areas.

bond issued to finance public works such as bridges or tunnels or sewer systems and supported directly by the revenues of the project. For instance, if a municipal revenue bond is issued to build a bridge, the tolls collected from motorists using the bridge are committed for paying off the bond. Unless otherwise specified in the indenture, holders of these bonds have no claims on the issuer's other resources.

mutual fund that invests entirely in tax-exempt obligations of governments and government agencies within a single state. Therefore, dividends paid on fund shares are not taxable to residents of that state when they file state tax returns although capital gains, if any, are taxable.

security whose payment is unconditionally promised by a governmental unit that has the power to levy taxes. Many state, county, city, town, and school district obligation bonds are of this type. General obligation bonds are backed by the full faith and credit (and taxing power) of the issuing government, whether it be the U.S. or a municipality.

municipal bond term referring to the debt of government entities within the jurisdiction of larger government entities and for which the larger entity has partial credit responsibility. For example, a township might share responsibility for the general obligations of a village within the township, the debt of the village being underlying debt from the township's standpoint. The term overlapping debt is also used to describe underlying debt, but overlapping debt can also exist with entities of equal rank where, for example, a school district crosses boundaries of two or more townships.

category of municipal bond as defined in the tax reform act of 1986, which is exempt from federal income taxes as long as it provides no more than 10% benefit to private parties and no more than 5% of the proceeds or $5 million are used for loans to private parties; also called public activity, traditional government purpose, and essential purpose bond. Public purpose bonds include purposes such as roads, libraries, and government buildings.

municipal bond issued by a state or local government, or by a development agency, to finance the private industrial projects generating tax revenues and certain public works projects. These bonds are of two types: development bonds financing the renovation or improvement of public facilities, and industrialrevenue bonds, for which a private corporation is responsible for payments to bondholders. Industrial bonds are subject to special IRS rules governing the tax exemption of interest. The tax exemption on many of these bonds, other than bonds financing airports, water treatment plants, and certain other public works related projects, was eliminated by the Tax Reform Act of 1986. Bond ratings on revenue bonds are based on the credit rating of the private corporation backing the lease or rental agreement covering the facilities, because the ultimate source of repayment is the corporation, rather than the bond issuer.

category of municipal bond distinguished from public purpose bond in the tax reform act of 1986 because 10% or more of the bond's benefit goes to private activities or 5% of the proceeds (or $5 million if less) are used for loans to parties other than governmental units. Private purpose obligations, which are also called private activity bonds or nonessential function bonds, are taxable unless their use is specifically exempted. Even tax-exempt permitted private activity bonds, if issued after August 7, 1986, are tax preference items, except those issued for 501(c)(3) organizations (hospitals, colleges, universities). Private purpose bonds specifically prohibited from tax-exemption effective August 15, 1986, include those for sports, trade, and convention facilities and large-issue (over $1 million) Industrial Development Bonds. Permitted issues, except those for 501(c)(3) organizations, airports, docks, wharves, and government-owned solid-waste disposal facilities, are subject to volume caps.