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Political Or Legal Risk


Sometimes the government can declare withholding or other additional taxes on a bond or declare a tax -exempt bond taxable. In addition a regulatory authority can conclude that a given security is unsuitable for investment entities that it regulates. These actions can adversely affects the value of the security.Similarly,it is also possible that a legal or regulatory action affects the value of a security positively. The possibility of any political or legal actions adversely affecting of a security is known as political or legal risk.

To illustrate political or legal risk, consider investors who purchase tax exempt municipal securities. They are exposed to two types of political risk that can be more appropriately called tax risk is that the federal income tax rate will be reduced. The higher the marginal tax rate, the grater the value of the tax-exempt nature of a municipal security. As the marginal tax rates decline, the price of a tax exempt municipal security will decline.

For example, in 1986 there were proposals to reduce marginal tax rates. As a result, tax-exempt municipal bonds began trading at law prices. The second type of tax risk is that a municipal bonds issued as tax-exempt will eventually be declared taxable by the Internal Revenue Service. This may occur because many municipal (revenue) bonds have elaborate security structures that could be subject to future adverse congressional actions & IRS interpretations. As a result of the loss of the tax exemption, the municipal bonds will decline in value in order to provide a yield comparable to similar taxable bonds.

For example, In June of 1980, the Battery Park city authority sold $ 97.3125 million in constriction loan notes.

At the time of issuance the legal counsel thought that the interest on the note would be exempt from federal income taxation, in November of 1980, however the IRS held that interest on those notes was not exempt resulting in a lower price for the notes the issue was not resolved until September 1981 when the authority & the IRS signed a formal agreement resolving the matter so as to make the interest on the notes tax-exempt.

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