What Your Broker Won’t Tell You about Municipal Bonds
With CD rates being so low, you might be looking for alternatives. When a loyal reader of this blog graciously offered to share his experience in municipal bonds, I thought this would be a nice change of pace for this blog. The reader has many years of experience in buying bonds and brokered CDs, and I'm very thankful he was willing to share his experience. The following is the guest post provided by this reader. Please note that unlike federally insured CDs, there is a risk of loss when investing in municipal bonds.
What your broker won’t tell you about Municipal Bonds.
The best place to purchase Municipal Bonds (Muni’s) is on the secondary market. When a broker tells you he is not making very much commission on selling you these, he is actually telling the truth.
Unlike new issues which have huge incentives, you can buy $10,000 of Muni’s on the secondary market and your broker could literally make $10.
So don’t sit back waiting for your broker to call you with available secondary bonds.
The reason I focus on the secondary market is because 99% of the time that is where you can get the best return, for those of you that aren’t familiar with the terms, secondary is just like it sounds. I call my broker and say I want to sell $10,000 of ABC Municipality.
My broker puts it up for sale, you see it listed and tell your broker I will give 95 cents on the dollar ($9500) so I sell at a loss to get out (like an early withdrawal penalty on a CD) and you end up with a higher rate of return because you paid 5% less (that scenario would be over the life of the bond, if there are five years left until maturity, you would be earning an additional 1% per year.)
If the bond matures rather quickly (1-5 years) you can often expect to pay above par (more then 100 cents on the dollar) thus reducing your rate of return.
I have watched CNBC and other business channels for years. I hear them talking about Municipalities not having any money, property taxes dropping, how Orange County, California went bankrupt (about 10 years ago) I never hear them say that no investor lost any money in the OC bankruptcy.
I have also never heard them say “buy bonds with insurance”.
With CD rates what they are (and yes you can sometimes find a good deal on the secondary market for CD’s as well) I buy quite a few bonds so I am speaking from experience. Here are the major things to look for:
I prefer tax free Muni Bonds, to you it may not matter.
Unless it is going to mature in the next couple of months (which those are hard to find) I like insured bonds.
There are only two insurance companies worth being insured by in my opinion I prefer them in this order: 1. BHAC (Berkshire Hathaway – aka Warren Buffet’s company) 2. AGMC You also want to know what the underlying rating of the Municipality is, for example: I own some Los Angeles County California Sanitation Bonds, they are rated AA+ by S&P and they are insured by AGMC which S&P rates AAA, these are tax free and pay 5% a year. They mature in 2014.
I paid slightly above par (101 cents on the dollar) for these because in my opinion they have very little risk of default and if they should, there is an insurance company to make good on it plus four years is a pretty short duration and these are tax free, making them worth more to me.
Bonds that generate revenue usually don’t fail so they are usually rated higher, these would include the above I just mentioned, Sales Tax Bonds, Water/Power Bonds/ some major airports are good.
You may wonder why you need to worry about the underlying rating if they have good insurance. Most insurance companies DO NOT insure your interest only the principal (It is not actually the insurance company it is the Municipality that buys the insurance, most don’t buy “interest protection”)
So if the above Municipality backing the bond I own went under, the insurance company is not required to pay me until 2014, the maturity date.
Municipal Bonds generally pay interest twice a year, whereas Corporate bonds can pay anywhere from monthly on... (Corporate Bonds are a whole other story)
I don’t like Muni Bond Mutual Funds for a couple of reasons, a fund manager decides what to buy and what and when to sell and you pay a management fee.
I prefer buying small amounts in several different municipalities.
You may be comfortable without the bonds being insured, I own some un-insured State of Illinois Sales Tax Bonds, these are rated AAA without any insurance because they are backed by the sales tax collected, I feel secure with that.
I also purchased some AGMC Insured bonds that I got below par. I get a tax free yield of 6.55%.
I am not talking about a lot of money here, the bigger brokers (Fidelity or Schwab) usually will sell you $5,000 minimum (the true discount like Ameritrade or Scottrade usually won’t sell you less then $10,000) so you are essentially building your own Municipal Bond Fund and you choose when you want to add to it, or sell a particular bond.
I don’t buy Zero Coupon bonds, these are bonds that you purchase at a substantial discount and they pay you Zero interest and then when they mature you get back the full value of the bond (remember you bought it at a steep discount) I don’t like these because what if they go bankrupt in 5-10 years, at least with the others you would have collected 5-10 years worth of interest.
Call any broker, even if you don’t have an account there and ask to speak to someone in fixed income, they will be happy to help you or answer any questions. (they are more helpful if you wait until the trading day is over if you're not a client.)
This can be a great alternative to CD’s in today’s low yield world, however remember no bond is 100% safe, not even with Warren Buffet’s name on it. You should only invest what you can afford to lose.
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