Choosing Between an In-State Premium Muni, an AMT Bond, and a Corporate
Elena, 66, has $900,000 to invest for income and capital preservation. She is in the 32% federal bracket, owes the 3.8% net investment income tax on taxable interest, and pays 5.5% state income tax in the state that issues the bond you are considering; she is a resident of that state. Her CPA has warned that she may be subject to the alternative minimum tax this year. Three candidates are on the desk: (1) an in-state AA general obligation bond, 4.00% coupon, 10-year maturity, offered at 108.00 with a yield to maturity of 3.35% and a yield to call of 2.10% if called at par in five years; (2) an out-of-state AA airport revenue bond, 4.25% coupon at par, yield 3.90%, structured as a specified private activity bond whose interest is an AMT preference item; (3) a 10-year A-rated corporate bond yielding 5.60%.
1. Compare the three candidates on an after-tax basis for Elena and recommend one.
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Bond 1, in-state GO. Interest is exempt from federal and state tax, so the taxable-equivalent yield is 3.35 / (1 − 0.375) = 5.36%. That is below the corporate's 5.60%, which is where most candidates stop - incorrectly.
Bond 3, corporate. After federal 32% plus 3.8% NIIT plus 5.5% state, the after-tax yield is 5.60 × (1 − 0.413) = 3.29%. The state tax is assumed non-deductible federally because the SALT cap binds at her income; if her state tax were deductible, the combined rate falls to about 35.7% and the after-tax yield rises to 3.60%. That is the single assumption that flips the answer, so verify it with her CPA.
On the binding assumption, Bond 1 wins narrowly: 3.35% versus 3.29%. A 6-basis-point edge is thin, so the qualitative factors decide: the GO is AA versus A, and it diversifies away from her taxable fixed income, but it carries call risk and a premium price.
Bond 2, airport AMT bond. Interest is state-taxable because it is out-of-state, and if the AMT applies it is taxed at 26–28% federally. After an assumed 28% AMT rate it yields about 2.81%, and less after state tax. The 55 bp pick-up over Bond 1 does not compensate for that. Recommend Bond 1 only if the call and premium issues are acceptable - see next.
2. Explain why the premium price and the call feature matter here, and how you would address them.
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Elena would pay 108.00 for a bond that can be redeemed at 100 in five years. The two yields on the sheet tell the whole story: 3.35% to maturity in 10 years versus 2.10% to the five-year call. If rates fall enough for the issuer to call - the scenario in which she most wants to keep the bond - she receives par early and gives back eight points of premium over five years, roughly a 1.5% annual drag. She is effectively short a call option and is not being paid much for it.
Three ways to handle it:
- Buy the non-callable or longer-call alternative. Ask the desk for the same credit with 10-year call protection or a par structure; a par bond removes the premium-amortization and reinvestment problem entirely.
- If she buys it, underwrite to the call. Size the position assuming 2.10% for five years, not 3.35% for ten, and make sure the ladder does not depend on that cash flow.
- Understand the tax mechanics. Municipal bond premium must be amortized against basis; there is no deductible loss when the bond is called or matures at par. Her reported tax-exempt income will be lower than the coupon, which surprises clients at tax time.
Given she wants capital preservation, a par bond with a shorter call is the better fit even at a slightly lower yield.
3. How does the AMT warning change your recommendation, and what do you do about it?
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It removes Bond 2 from consideration and creates an ongoing monitoring obligation. Private activity bond interest is included in alternative minimum taxable income, so if Elena is an AMT payer she loses the federal benefit that justified the out-of-state airport revenue bond, while still paying state tax on the interest because she does not live in the issuing state. The double hit is worse than the headline 3.90% suggests.
Concretely:
- Ask the CPA for the prior year's Form 6251 and a projection for the current year before the trade, not after. If her AMT exposure is borderline, the bond could tip her into or out of the regime, and the answer may differ year to year.
- If she already holds AMT bonds from a prior adviser, quantify the amount and consider selling the highest-premium lots first, since AMT bonds purchased at a premium have their own basis complexities.
- Do not assume the warning is permanent. The AMT exemption phases out at higher income, so a change in her income - a large Roth conversion, an IRA distribution, the sale of a property - can move her status in either direction.
Document the CPA consultation in the file. If the CPA cannot be reached before settlement, default to Bond 1, the in-state non-AMT bond, because it is robust under both AMT outcomes.