Rosalind holds a federally tax-exempt municipal bond fund purchased chiefly for the exemption. Her representative notes that one risk of the position has nothing to do with the credit of the issuers or the direction of interest rates. That risk is BEST described as:
- A.Credit risk, because municipalities can default on their obligations.Credit risk is real for municipal issuers but the stem excludes issuer credit from the answer.
- B.Reinvestment risk, because coupons must be reinvested at prevailing rates.Reinvestment risk is a rate-driven exposure, which the stem also excludes.
- C.Legislative risk, because the tax exemption that justifies the position exists only by statute and can be changed.Correct. The value of the exemption depends on tax law, so a change in law is the distinct risk here.
- D.Currency risk, because municipal issuers borrow in several currencies.Domestic municipal bonds are denominated in dollars, so currency risk is not implicated.
Why: Legislative or political risk is the risk that a change in law alters the economics of an investment. For a municipal bond fund the tax exemption itself is a creature of statute; a reduction in marginal tax rates or a change in the treatment of municipal interest would reduce the after-tax advantage that justified the purchase, and prices would adjust accordingly.
Fenmore Municipal Income Fund, a registered open-end fund holding only investment-grade municipal bonds, makes two distributions for the year to shareholder Ingrid Halloway, who owns the fund in a TAXABLE account: $2,400 designated as exempt-interest dividends and $900 of long-term capital gain distributions. For federal income tax purposes:
- A.Both distributions are free of federal income tax, because the fund holds only municipal bonds.Incorrect. Only the interest component keeps its tax-exempt character. Gains the fund realizes by selling bonds are taxable when distributed.
- B.Both distributions are taxed as ordinary income, because they are paid by a mutual fund rather than received directly from the issuers.Incorrect. A regulated investment company may designate exempt-interest dividends, which pass the exempt character of municipal interest through to shareholders.
- C.The $2,400 is tax free only if Ingrid held her fund shares more than one year; otherwise it is ordinary income.Incorrect. The exclusion for exempt-interest dividends does not depend on the shareholder's holding period. Holding period matters when she SELLS her shares.
- D.The $2,400 is excluded from her federal gross income as tax-exempt interest, while the $900 is taxable as a long-term capital gain.Correct. Exempt-interest dividends pass through tax free; capital gain distributions are taxable, and their long-term character is determined at the fund level.
Why: A regulated investment company that holds primarily municipal securities may pass the tax-exempt character of its interest income through to shareholders by designating the payments as exempt-interest dividends; those amounts are excluded from federal gross income. The pass-through applies only to the INTEREST the portfolio earns. When the fund sells bonds at a gain and distributes the proceeds, that is a capital gain distribution and it is fully taxable - as long-term gain if the fund held the bonds long enough, regardless of how long the shareholder has owned the fund.