"Investing - Municipal (Muni) Bonds"
By Ron Stultz
16 June 2011
Summary: I like municipal (Muni) bonds. Investing in Muni bonds is a good way to get Federal and state income tax free interest on your money than is higher than certificates of deposit (CD). However, unlike a CD, it is possible to loose some or all of your principal, if the bond issuer defaults or if a Muni bond has to be sold before it is called or matures.
Background:
States, counties, cities and other approved organizations, such as churches, borrow money to fund various projects or efforts.
Money is borrowed via the issue of Muni bonds.
A Muni bond is a promissory note in that from the date of issue of the bond, the organization promises to pay to the Muni bond holder, a defined interest percentage on some sort of periodic basis (usually, annually or semiannually).
When a Muni bond is issued, it has a a defined period or life. A typical Muni bond term or life period is 30 years from issue date.
When a Muni bond reaches its end of life, the Muni bond is known to have matured and the issuer pays the bond holder the face value of the Muni bond.
Although issued for a specific time period, the issuer of the Muni bond usually has the right to "call" or redeem the bond earlier that the defined maturity date. This date, defined with the bond, is known as the "first call date."
Some Muni bonds carry a slight "bonus" if the Muni is called before the maturity date.
Muni bonds are typically issued as "book entry" meaning that the issuer does not actual create pieces of paper that it sends to each bond holder but rather an electronic transaction is recorded between the issuer and the various investment companies used by bond holders.
The attraction to Muni bonds is that interest paid the bond holder can be free of Federal and state income taxes.
"Can be free." The Federal income tax code was changed in the 80's to prevent high income persons from simply investing all their money in Muni bonds and not paying any Federal income tax at all.
Known as the alternative minimum tax, some Muni bonds are subject to the alternative minimum tax and will be so noted by the issuer. In most cases, bonds that are issued by organizations not a state, city or county are subject to alternative minimum tax.
"Can be free." The interest paid on a Muni bond by one state is not typically state income tax free if the bond holder is resident of another state.
Muni bonds pay a higher percentage interest rate that a CD.
The interest rate paid on a Muni bond is a function of the financial status of the issuer as well as the prevailing rates on similar Muni bonds. Once upon a time when the government of Washington, D.C. had financial problems, their Muni bonds had to carry an interest rate several percentage points higher than surrounding state Muni bonds.
Muni bonds are not insured by the Federal Deposit Insurance Corporate (FDIC) like CD's are.
Muni bonds are liquid, meaning there is a market for resale but Muni bonds are not quite as liquid as stocks.
All Muni bonds have a credit worthiness rate assigned by the brokerage company hosting the bonds or an independent third party. The rating of a Muni bond can go up or down, depending on the financial state of the issuer and his ability to make interest payments and return principal when bonds mature.
To make a Muni bond issue attractive to bond buyers, some issuers buy insurance on the Muni bond such that if the issuer defaults or can not pay either the interest or principal, the third party insurer will pay.
Some Muni bonds issued by a county or city are backed by the state government such that if the county or city tries to default on the bond, the state will assume liability and pay bond holders. But there are very few Muni bonds like this.
Muni bonds are available though brokerage companies and the brokerage component of banks.
The lowest domination Muni bond is $1000. However, most trading in Muni bonds is done at the $20,000 or block level. As with stocks, the lowest price to buy or the highest price when selling will be when an entire $20,000 block is moved.
There is always a commission paid when you buy or sell a Muni bond. This commission amount is bundled into the buy or sell price of the Muni bond and you do not see it, but it is always there. A few days after you buy a Muni bond, if you can see your account, you will see the value of the Muni bond you bought is less than the amount you paid for it. The difference between your cost and current value is mostly commission paid.
There are also mutual funds that have nothing in them but Muni bonds. I am not a fan of Muni bond funds.
Muni bonds in summary:
Issued by states, counties, cities and other organizations.
A promissory note with a defined borrow period and percentage rate of return.
Most Muni bonds are free of Federal and state income taxes.
Muni bonds carry a credit worthiness rating than can go up or down and this rating affects the current valve of the bond.
Some Muni bonds are insured by an independent third party.
Muni bonds can be called or redeemed before their defined life span is over or they mature.
At Muni bond sale or call or redemption, it is possible that the Muni bond will generate a capital gain or loss, depending on the amount paid for the bond initially, that must be reported on Federal and state income tax returns.
Buying and selling Muni bonds:
It is rare to buy a bond at the time of it's issue or at its face value. When bonds are first issued, one brokerage company might take the entire issue and sell them to its best customers.
If you are lucky enough to buy a bond when it is first issued, you most likely will pay the face value of the bond or what is known as "par". If you buy $5000 worth of a Muni bond and pay $5000, you have bought the bond at "par."
After a new issue has been sold, bonds of the issue enter the "secondary market."
All bonds bought or sold after the initial issue are in the "secondary market."
When bonds are issued, they have a specific time period and rate of interest.
All bond investors want the highest rate of return on their money.
If a Muni bond in the secondary market has a defined 5% interest rate but new issues are paying 5.5%, why would an investor buy an older bond paying only 5% when he could buy a newer issue paying 5.5%?
To make an older, lower paying interest rate, Muni bond attractive to buyers in the secondary market, the older bond must be reduced in price or discounted so based upon the selling price, the buyer will receive an interest rate on his money equal to the prevailing interest rate of new issue Muni bonds.
If you buy a bond in the secondary market and pay less per bond that its face value you are buying a bond below par.
If you buy a bond in the secondary market that has an interest rate higher than prevailing interest rates of new issues, you will pay more per bond than its face value or above par. By paying more for a higher interest rate bond that current, prevailing rates, your are investing more money that results in you receiving interest equal to the percentage rate of prevailing Muni bonds.
When you sell a bond, if the prevailing interest rate is higher than what you are receiving on the bond you are selling, your bond will sell for less than its face value. Depending on when you bought the bond, this may result in a loss of principal or you receive less for the bond that you paid for it.
When you sell a bond, if the prevailing interest rates of new issues is lower than the interest rate you are getting on your bond, the bond will sell for more than its face value or above par. This transaction might generate a capital gain that must be reported on your Federal and state income tax returns.
The upside of investing in municipal bonds:
Defaults on Muni bonds issued by states, counties and cities are rare. There have been some but not many.
If you do not have to sell a bond before maturity, your principal is safe and will be returned to you.
Bonds can provide a tax free income stream.
If you are in one of the higher income tax brackets, tax free interest can be very attractive. It can be very difficult to invest in something other than Muni bonds and after paying income taxes, get a post-tax return on your money equal to that kicked off my a Muni bond.
Bonds take very little management. You buy them and unless they are called, never think about them.
The interest rate you can get on a municipal bond is higher than a CD.
The downside of investing in municipal bonds:
While Muni bond defaults are rare when states, counties and cities issue the bonds, other organizations that qualify to issue Muni bonds do have some history of defaults. If at all possible, stay away from Muni bonds issued by anyone other than a state, county or city.
Potentially a loss of principal if the bond goes into default or you have to sell at a bad time.
The interest paid on a bond is fixed. This is a good thing in times of decreasing interest rates but not such a good thing with interest rates are raising. It is possible that you can get stuck with a bond paying 4% while a new bond issue might be paying 6%.
If you have to sell a bond, the price you will get for the bond can be either equal to the face value of the bond, above the face value or below face value. If prevailing interest rates are above the rate on your bond, the bond has to be discounted for a seller to be attracted and buy this. This can result in a capital loss or loss of principal.
Bonds can and are called. If prevailing interest rates drop below the rate of your bond, the issuer might call your bond, return your principal and then issue new bonds with an interest rate more in line with prevailing interest rates. The problem here is that if you want to replace the bond, you will have to do so with a bond paying less of an interest rate.
Muni bonds are not considered an investment bought for growth. The hype, attraction of stocks is that over time, a company grows its business, investing in new facilities, etc, etc with its core "worth" going up and thus, supposedly, its stock value. Thus stocks can have a growth component. Muni bonds can not "grow." If all goes well and according to plan, when a Muni bond matures, you will get from the issuer the face amount of bonds you have maturing. You will not get any more or any less than face value, thus no growth component.
Municipal bond funds:
You can get into Muni bonds via mutual funds.
The advantage of a Muni bond mutual fund is that you can start with a very small amount of money and dollar cost average additions.
Another advantage of a Muni bond mutual fund is that it probably holds Muni bonds from many different states, cities and counties and thus the risk of defaults is reduced over owning only 1 or 2 Muni bonds directly.
Finally, the Muni bond mutual fund manager stays on top of the bonds in the fund portfolio such that if it appears that a bond issuer might have trouble making interest payments or even default on the bonds in the future, the fund manager and sell the bond and replace it. Only if you own a significant quantity of Muni bonds at one brokerage house will you get any sort of bond issuer watching and alert to potential problems.
The disadvantage of a Muni bond fund is that there are times that the fund manager will have to sell some bonds to cover requests for fund withdraws and some bonds may have to be sold at a loss. Mutual funds try to keep a cash reserve to handle expected requests for withdrawals but sometimes withdraws outstrip cash reserves.
Muni bond funds typically pay a lower percentage rate than you can get if you buy a Muni bond yourself.
A Muni bond mutual fund can general either a capital gain or loss, annually, that must be reported on your income tax return.
Because a Muni bond mutual fund will hold Muni bonds from multiple states, only some portion of the interest received will be income tax free in your state of residence.
Not recommended for an IRA or other tax deferred account:
Hope it is obvious by now, but with Muni bonds kicking off Federal tax free interest, there is no advantage to hosting Muni bonds in any sort of income tax deferred account such as an individual retirement account (IRA), self employed pension (SEP) or other.
My personal experiences:
Significant less stress than being in the stock market. Yes, the value of my bond portfolio goes up and down but never by a lot and certainly not like an individual stock can.
Significant less cost basis tracking than being in the stock market directly or via mutual funds.
So far, every bond I have ever bought has never made it to maturity. All have been called. The average life span has been about 6 or 7 years.
I have owned and still own a significant amount of Muni bonds. In the recession starting in 2008, I have had 2 bonds go into default. In both cases, the bonds were issued by an organization other than a state, county or city.
I once was into Muni bond funds but the funds seem to generate either capital gain or loss every year.