Bond Guide

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Hennion & Walsh is an independent financial services firm specializing in Municipal Bonds. It is our heritage, it is who we are. We have been helping individual investors build strong bond portfolios for over 20 years. We are committed to helping the individual investor learn more about their investments. If you have any additional questions, please feel free to call us at (800) 836-8240.

Municipal Bonds The Basics

Municipal Bonds are issued by state and local governments to raise money for major capital projects. This includes the building of infrastructure such as bridges, roads, hospitals, schools, sewer systems, stadiums, airports, power plants, and prisons, or to provide for other needs of local government. Virtually all states and local governments issue municipal bonds from time to time. The $2.7 trillion* municipal bond market consists of over 50,000 issuers across the country.

...interest income is exempt from state and local taxes if the investor lives in the same state as the bond issuer.
Like any borrower, local governments pay interest on municipal bonds to investors that own or hold them. Interest on municipal bonds is typically paid every 6 months. Interest earned from municipal bonds is exempt from federal income taxes, and, depending on the residence of the bond holder, may also be free of state and local taxes.

Investors have viewed municipal bonds as safe investments because their default rate has historically been less than 1%**.
As a general rule, interest income is exempt from state and local taxes if the investor lives in the same state as the bond issuer. For example, a New Jersey resident owning a New Jersey State municipal bond would not have to pay federal or state taxes on the interest received from this bond. Investors have viewed municipal bonds as safe investments because rated investment grade municipal bonds have had an average cumulative default rate of just 0.08% between 1970 and 2011.**. The reason for this low historical rate of default is that many municipal bonds are backed by the unlimited taxing power of the local government issuing them. Such bonds are referred to as General Obligation Bonds (or GO), and are backed by the full faith, credit and taxing power (i.e. income, property, sales, and vehicle taxes, tolls, special levies, etc.) of an issuer*** to pay back the principal and interest owed to bondholders. General Obligation Bonds thus offer a measure of safety to bondholders because unlike corporations, local governments rarely cease to exist and dissolve altogether. As long as they exist, municipalities should be able to generate tax revenue sufficient to meet their obligations to bondholders. Another type of municipal bond is a Revenue bond which is backed not by taxes, but by revenue (i.e. toll revenue or electric power revenue). The safety of a bond will vary based on the revenue streams backing it, which is why we recommend working closely with a municipal bond expert.
* Lazard Insights, December 15, 2009 ** Moodys Investor Service, U.S. Municipal Bond Defaults and Recoveries, 1970-2011, March 7, 2012 *** Municipal Securities Rule Making Board Website

Municipal Bonds: Five Must-ask Questions For Investors

Q. What is a municipal bond? A. A municipal bond is essentially a loan to the government.
It is a debt instrument issued by a state, county, city or other government entity to raise money for general or specific purposes. The issuer agrees to pay the bondholder interest on the principal. The interest rate is also called the coupon rate and is usually paid twice a year. These payments continue until the bonds maturity date, at which point the issuer repays the principal (also called face value or par value) in full. Most municipal bonds are tax-free, so the bondholder doesnt have to pay taxes on their regular interest payments. There are two kinds of tax-free municipal bonds: general obligation bonds and revenue bonds. General obligation bonds raise money for projects that benefit the community at large, and are backed by a governments full faith and credit and unlimited taxing power in short, by their ability to tax. In contrast, revenue bonds fund specific projects and are backed solely by the revenues generated from those projects.

Insured bonds carry an extra degree of security from risk... Example: A general obligation bond may be issued for a large, non-revenue producing capital project such as a public building or a health facility. A revenue bond may be issued by a public transit authority to finance the construction of a new subway line.
Insured bonds carry an extra degree of security from risk because they are insured by a third party. If the bond issuer goes into default, the insurer will continue to make regular interest payments to bondholders and will redeem the principal upon maturity. Alternatively, insurers may pay off the bonds at a future call date.

Q. How can municipal bonds be a cornerstone for an individual investors portfolio? A. M  unicipal bonds offer investors three primary advantages potential tax-free
income, potential safety of principal, and potential regular predictable income. Potential Safety of Principal:
Many investors, particularly those nearing retirement or in retirement, are concerned about protecting their principal. In March of 2012, Moodys published research showing that rated investment grade municipal bonds had an average cumulative default rate of just 0.08% between 1970 and 2011.* That means while there is some risk of principal loss, investing in rated investment-grade municipal bonds can be a cornerstone for safety of your principal.

Potential Regular Predictable Income:

Municipal bonds typically pay interest every six months unless they get called or default. That means that you can count on a regular, predictable income stream. Because most bonds have call options, which means you get your principal back before the maturity date, subsequent municipal bonds you purchase can earn more or less interest than the called bond. And according to Moodys 2012 research,* default rates are historically low for the rated investment-grade bonds favored by Hennion & Walsh.

Potential Triple Tax-Free Income:

Income from municipal bonds is not subject to federal income tax and, depending on where you live, may also be exempt from State and local taxes. Triple tax-free is always a big attraction for many investors, especially at a time when tax increases are likely. Generally, interest income from municipal bonds issued by a State or local government is exempt from Federal Income Taxes (although some bonds may be subject to the Alternative Minimum Tax), and also exempt from income taxes in the State the municipal bonds were issued by. A New York General Obligation Bond therefore is exempt from Federal Income Taxes, as well as New York State Income Taxes. The only States that do not exempt Municipal Bonds entirely from the State Income Tax are Illinois, Iowa, Oklahoma, Utah, and Wisconsin. For residents of those States, buying the most appropriate bonds, even if outside their State of residence, may make the most sense, as they will be exempt from the Federal Income Tax only.

* Moodys Investor Service, U.S. Municipal Bond Defaults and Recoveries, 1970-2011, March 7, 2012

Q. What is the primary risk associated with investing in municipal bonds? A. The primary risk associated with bonds is interest rate risk.
Bond prices and interest rates fluctuate inversely, so your bonds value on the secondary market will drop if interest rates rise. However, this will only affect you if you decide to sell your bond prior to maturity. If you hold your bond to its maturity date, you can expect to receive regular interest payments throughout the term and the face value of your bond upon maturity.

Q. Should I buy individual bonds or funds? A. That depends on your goals.

If your priorities are stability and regular, predictable income, you should concentrate on highly rated individual bonds and plan to hold them to maturity. Sometimes people are tempted to invest in bonds with lower credit ratings, including so-called junk bonds, because they offer higher interest payments. In these cases, we generally recommend investing in a bond fund instead. Bond funds are administered by investment professionals who can spend the time and put in the research necessary to pick a range of bonds that will offer more competitive yields. The drawback to a bond fund is that, because the mix of individual bonds changes over time, your principal and interest cannot be guaranteed.

Q. What strategies should I use for smart bond investing? A. M  any of the principles that apply to investing as a whole also apply
specifically to bond investing.
As a general rule, the higher your income tax bracket, the more you may benefit from tax-free municipal bonds. The ratings of general obligation and essential purpose revenue bonds can vary, and individual ratings are highly dependent on the particulars of a given issue. A practice called bond swapping that is, selling one bond and immediately using the proceeds to invest in another can help you take advantage of changes in interest rates or in your personal tax situation. As with all municipal bond purchases, bond swaps are subject to credit and interest rate risk, which are both explained later in this guide. Often, you can offset capital gains with a tax loss incurred by selling bonds below their purchase price. Ask your tax advisor for the most up-to-date advice.

As a general rule, the higher your income tax bracket, the more you may benefit from tax-free municipal bonds.*

* Municipal Bonds may be subject to the Federal Alternative Minimum Tax.

Did You Know?

Interest payments.
Interest on municipal bonds is usually paid semiannually. On notes, interest is typically paid at maturity.

Minimum investment.

Most tax-free municipal bonds are issued in denominations of $5,000 or integral multiples of $5,000. Most notes are also available with a minimum denomination of $5,000.

Payment terms.

Dealers are required by the US Department of the Treasury to have payment for a securities purchase and to make payment for a securities sale no later than the third business day following the day of the trade (also referred to as settlement date). If you sell your bonds prior to maturity, you will receive the current market price, which may be more or less than the original cost.

Marketability.

Holders of municipal bonds can sell their bonds in the secondary market through one of the many banks and securities dealer firms which are registered to buy and sell municipal securities. Municipal bonds are sold in the over-the-counter market instead of an organized exchange. If you sell your bonds prior to maturity, you will receive the current market price, which may be more or less than the original cost.

Understanding Risk
When investing in municipal bonds, investors should principally be aware of three types of risk.

Market Risk.

While the interest payment cannot be changed during the life of a bond (unless it is a variable rate security), the market price of a security fluctuates as market conditions change. If you sell your municipal bonds prior to maturity, you will receive the current market price, which may be more or less than the original cost.

Credit / Default Risk.

If a local government declares bankruptcy, it can default on its bond obligations, which may cause bondholders to lose part or all of the principal they invested. Although defaults have occurred at an overall rate of less than 1% since World War II, we encourage investors to work with a municipal bond expert to carefully choose the municipal bonds they plan to invest in. This means that they should also understand the underlying credit ratings and insurance status of municipal bond issues.

Reinvestment Risk.

The risk that future coupons from a bond will not be reinvested at the prevailing interest rate when the bond was initially purchased. Reinvestment risk is more likely when interest rates are declining. Reinvestment risk affects the yield-to-maturity of a bond, which is calculated on the premise that all future coupon payments will be reinvested at the interest rate in effect when the bond was first purchased.

...we encourage investors to work with a municipal bond expert to carefully choose the municipal bonds they plan to invest in. Interest Rate Risk.

As with other fixed income securities, municipal bond prices fluctuate in response to changing interest rates. When interest rates fall, new issues come to market with lower yields than older securities, making the older securities worth more. Conversely, if interest rates rise, new issues come to market with higher yields, making older issues less attractive.

Understanding Calls
Many bond issues allow the issuer to call or retire all or a portion of the bonds at a premium or at par, before maturity. When buying bonds, be sure to ask about call provisions.

Glossary
Asset allocation:
A portfolio management strategy that divides assets among broad categories of investments, including stocks, bonds and cash.

Asset class:

An investment category such as stocks, bonds, cash and cash equivalents, real estate, collectibles and precious metals.

Bid:

The price at which a buyer will purchase a security.

Bond:

A loan from an investor to a corporation, government, federal agency or other organization. The recipient of the loan, also called an issuer, usually agrees to pay interest on the loan at a specified rate at regular intervals, and will repay the loan in full on a future date.

Call:

The bond issuers right to redeem outstanding bonds before their stated maturity date.

Call Premium:

The amount over the par value that the bond issuer must pay the bond holder if the bond is redeemed before its stated maturity date.

Coupon:

The interest payment made on a bond, usually paid twice a year.

Discount:

When a bonds market price is lower than its issuing value, it is said to be trading at a discount. A bond issued at $1000 face value and trading at $850 carries a $150 discount.

Double Exemption: Maturity Date:

Securities exempt from state and federal income taxes are referred to as double exempt.

A set date in the future when the issuer will repay the full amount of the bond to the bond holder.

Par Value:

The face value or price at issuing. A bond trading at par is worth the same amount at which it was issued usually $1000 per bond.

Premium:

When a bonds market price is higher than its issuing value, it is said to be trading at a premium. A bond issued at $1000 face value and trading at $1150 carries a $150 premium.

Principal: Ratings: Swap:

The face value or original amount of money invested.

Designations used by ratings services designed to give relative indications of credit quality.

The sale of a block of bonds and the purchase of another block of similar market value. Swaps may be made to lock in a tax loss, upgrade credit quality, extend or shorten maturity or lock in higher yields.

Yield:

The return earned on a bond, expressed as an annual percentage rate.

Bond Ratings
Standard & Poors Corp AAA Highest Quality; principal & interest well protected. AA High Quality; marginally higher long-term risk than AAA. A  Good Quality; somewhat more susceptible to adverse conditions over the long term. BBB Adequate; adverse conditions could threaten principal or interest payments. BB  Questionable; faces major uncertainties. Adverse conditions could jeopardize prin/int payments. B  Speculative; adverse conditions would likely impair ability to pay interest or repay principal. CCC Risky; has been identified as being vulnerable to default. D In default Moodys Investors Service, Inc. Aaa  Highest quality; principal is well protected and interest payments are virtually assured. Aa High Quality; marginally higher long-term risk than AAA A  Good Quality; many favorable investment aspects. Suggestion credit risk could increase over time. Baa  Medium Grade; neither highly protected nor poorly secured: may be regarded as somewhat speculative. Ba  Lack characteristics of desirable investment; protection of prin/int payments over long term is small. B Ca C Speculative; with only moderate protection of principal and interest payments. Highly speculative; issues may be in default or have other large shortcomings. Lowest rated; extremely poor chances of ever attaining investment standing. Caa Poor Quality; may be in default and protection of principal is questionable.

Table of Tax-Exempt / Taxable Yield Equivalents (Tax-year 2014)

Taxable Income* Sample Effective Marginal Rate for Certain High-Income Taxpayers 39.6% Single Return $0- $9,075- $36,900- $89,350- $186,350- $405,100- $9,075 $36,900 $89,350 $186,350 $405,100 $406,750 Joint Return $0- $18,150- $73,800- $148,850- $226,850- $405,100- $18,150 $73,800 $148,850 $226,850 $405,100 $457,600 Tax Bracket 10% 15% 25% 28% 33% 35%

Tax-Exempt Taxable Yield Yields (%) Equivalents (%) 1.00 1.11 1.18 1.33 1.39 1.50 1.67 1.76 2.00 2.08 2.00 2.22 2.35 2.67 2.78 2.50 2.78 2.94 3.33 3.47 3.00 3.33 3.53 4.00 4.17 3.50 3.89 4.12 4.67 4.86 4.00 4.44 4.71 5.33 5.56 4.50 5.00 5.29 6.00 6.25 5.00 5.56 5.88 6.67 6.94 5.50 6.11 6.47 7.33 7.64 6.00 6.67 7.06 8.00 8.33 6.50 7.22 7.65 8.67 9.03 7.00 7.78 8.24 9.33 9.72 7.50 8.33 8.82 10.00 10.42

1.49 2.24 2.99 3.73 4.48 5.22 5.97 6.72 7.46 8.21 8.96 9.70 10.45 11.19

1.54 2.31 3.08 3.85 4.62 5.38 6.15 6.92 7.69 8.46 9.23 10.00 10.77 11.54

1.66 2.48 3.31 4.14 4.97 5.79 6.62 7.45 8.28 9.11 9.93 10.76 11.59 12.42

How to use this chart: 1. Find the appropriate return (single or joint). 2.  Determine your tax bracket by locating the taxable income category that you fall into. Taxable income is income after appropriate exemptions and deductions are taken. (The table does not account for special provisions affecting federal tax rates, such as the Alternative Minimum Tax.) 3.  The numbers in the column under your tax bracket give you the approximate taxable yield equivalent for each of the tax-exempt yields in the near left column. Example: If you are single and have a taxable income of $100,000 ($150,000 if married), you would fall into the 28% tax bracket. According to the table, you would need to earn 6.94% on a taxable security to match a 5% yield from a tax-exempt security.
* The income brackets to which the tax rates apply are adjusted annually for inflation. Those listed above are for2014. ** Tax circumstances are unique for each tax payer. Please consult your Tax Advisor to discuss your specific situation.

2001 Route 46, Waterview Plaza, Parsippany, NJ 07054 (973) 299-8989 (800) 836-8240 Fax (973) 299-0692 www.hennionandwalsh.com Securities offered through Hennion & Walsh Inc. Member of FINRA, SIPC.