Asked in Investing and Financial MarketsBonds and Treasuries
Should a business consider purchasing a municipal bond?
October 18, 2007 4:16PM
Yes, under certain circumstances and for the right reasons. Tax-paying businesses who have significant, excess cash (>$500,000) might consider the use of Federally tax-exempt municipal bonds and certain varieties of tax-exempt instruments, provided such investment can support any future need for liquidity that the business can be expected to have. For this reason, the maturity date (or the date upon which any tax-exempt security can be liquidated without any profit or loss result) should match any anticipated or normal need for liquidity. Further, only the highest quality (triple-A) vehicles should be contemplated. For tax-paying businesses, Federally tax-exempt investments can produce a better return than taxable alternatives (t-bills, commercial paper, bank deposit facilities, etc.) when the effect of the taxation is taken into consideration. As an example, say a business could invest in a sweep facility at its bank and get 5.00%, about where rates are currently (Oct. 2007.) Most businesses pay Federal income tax at the flat rate of 35%. This means that the bank's rate of 5.00% is really 3.25% after tax (5.00 X 0.65 = 3.25). Tax-exempt rates today are at about 3.50% for triple-A rated bonds maturing in 6 months. The difference of 0.25% (25 basis points) is equal to $2,500 in extra annual income for every $1 million invested. (N.B. - Shorter-term tax-exempt instruments whose rates float periodically are aberrationally high as of the time of this writing, averaging about 4.50%. This is largely due to the effect on the short term credit markets caused by the sub-prime debacle. Such rates would normally be only a bit higher than 6 month rates, or about 3.75% presently.) There are more considerations to be understood when a business or corporation chooses tax-exempt investments, especially for public companies. Don't do this without professional assistance from a broker, an experienced corporate attorney, or your tax advisor - preferably all three!