About Ken Tumin

Ken Tumin founded the Bank Deals Blog in 2005 and has been passionately covering the best deposit deals ever since. He is frequently referenced by The New York Times, The Wall Street Journal, and other publications as a top expert, but he is first and foremost a fellow deal seeker and member of the wonderful community of savers that frequents DepositAccounts.

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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.

Copyright (c) 2010

Alan Krigman
Alan Krigman   |     |   Comment #1
I agree "almost" completely.

One point of disagreement, and this is a matter of preference rather than fact, is that I prefer to buy bonds on the secondary market with coupons (the interest rate based on 100 par value) above 4.5% and prices below par (i.e., for less than 100). Under current economic conditions, with interest rates in general so low and the likelihood of taxes going up, prices on the secondary market for tax-free bonds with these interest rates have been slowly climbing and can be expected to keep doing so. This means that if you want to cash out for some reason, you can do so at a price above what you paid; there would be a capital gain, but you're still ahead.

My other point of disagreement is that some bonds may be insured to pay back the principal on the maturity date and not cover the interest payments, but others are the opposite... the insurance pays the interest but the issuer is still on the hook for the principal. I believe this is the case for the City of Harrisburg bonds that have been in the news lately.

And there's one point that the post doesn't cover. Some (many) bonds can be "called." Meaning that the issuer can redeem them in advance of the maturity date. There are several ways calls are implemented -- more than is appropriate for this "comment." But it's something about which you should ask your broker.

Two more things...

1) Build America Bonds are municipal bonds with federal government guarantees. The good news they're virtually risk-free. The bad news is they're not tax-free.

2) Tax-free bonds are not subject to federal taxes. They're only exempt from state and local taxes if the issuer is in your state or in Puerto Rico, the Virgin Islands, or Guam.
Richard   |     |   Comment #2
Corporate securities is another way to go.  While everyone is fretting about their 1.5% to 2.0% CD’s , I’m making a guarantee of 10%.  Of course it is not FDIC insured and you can lose your principle. But if you still with invested graded bonds that are rated A or better I’d rather take a gamble than be content with 2% if you can get it.  The bonds are purchased long term, usually 15-20 years.  But there is a secondary market on them and you can sell them if you need money.  Sometimes you may loose some money, but sometimes you make more money selling it on the secondary market rather than waiting it to mature (sometimes substantially more!).  The company that I am with was paying me 6.0125% interest after the 2000 stock meltdown when 1.5% looked attractive.  I don’t keep all of my eggs in a basket, so even if there is a downturn I shouldn’t be hurting.  But these egg “hatchlings” have grown to be very big birds!  On another note, investors are flocking more and more to junk bonds.  Although there are some good ones out there, I would be very hesitate to buy any.  At the current time I do not own any junk bonds and do not plan to.  But the payoff can be 30% to 40%.

My advice is to do a lot a research before making a purchase.  I have been buying alterative investments for about 10 years know.  I haven’t been burnt yet, but my day may be coming (even though I don’t so because I look at the strength of the company and the direction they are going before buying).

If you have a few bucks that you can spare and don’t mind loosing, these investments may prove to be the best thing that has happened to you financially.  These investments are not for everyone, so buyer beware!
Anonymous   |     |   Comment #3
One thing that happened to me concerning insured municipal bonds:  about a year ago, our Vanguard Long Term Insured Municipal Bond Fund was cancelled TOTALLY.  We were given the option to roll the money into a stock fund or another fund. Our fund was canceled during the time that our money was  way down so we lost out on this one. 
Anonymous   |     |   Comment #4
Does anyone know of a good guide to buying municipal bonds on the secondary market, like the author is talking about, and a source to the current rates of bonds for sale?
Stewie   |     |   Comment #5
@Anon #4;

Here's a link to one  http://content.municipalbonds.com/2009/02/28/how-to-buy-municipal-bonds/
goldsheet   |     |   Comment #6
Great muni info at: http://emma.msrb.org/


EMMA’s market activity pages provide a window for viewing market-wide information about municipal securities. Click on the tabs below to view recent trade data, official statements, continuing disclosures, advance refunding documents, daily market statistics, and recent data on auction rate securities (ARS) and variable rate demand obligations (VRDO)."

You can see the actual spreads (sometimes huge) and download all official documents to know EXACTLY what you are buying.
Jim davis
Jim davis   |     |   Comment #8
 If you look closely at the trades at EMMA Market Activity, you can see how the dealers are in some cases robbing you blind.  Look for the interdealer trades and the customer price for the same issue .  Upwards of 2% markups (thats 2000 on a 100k trade.)
andybuji   |     |   Comment #9
A word to the wise, especially about corporate bonds.  In December 2007, almost a year before the crash of 2008, I bought $10,000 of WaMu's subordinated 8.25% notes.  It was a 10 year issue, matruing 4/2010.  It was selling at a discount, yielding 9.001% to maturity.

Obviously, there being NO FREE LUNCH, there was an element of risk involved that was off of the individual investor's radar.  And, indeed, as time went by the price continued to drop.  But what the heck - as long as I was committed to holding to maturity, I couldn't get hurt, right?  We were talking about the sixth largest bank in the United States.  How could I lose money on this transaction?

Well we all know the ending to this story.  WaMu became the largest bank failure in history - I ended up getting $1500 back at the bottom.  All the careful diligence, the accumulation of returns from other corporates over the years, wiped out.  Lesson learned.  If I'm going to buy corporate debt, it's going to be in a bond fund.
andybuji   |     |   Comment #10
Hey Ken - about these Los Angeles County California Sanitation Bonds,  Got a CUSIP on those?  Did you buy these in the beginning of 2009?  You make it sound as if insured munis with a 5% coupon are selling now for a slight premium.  But 5% CA insureds due around 2014 go routinely these days for 111-114, not 101.  As in everything, NO FREE LUNCH.

Specifics please.  And how much premium do you demand for the black box purchasing of munis, especially in CA, over the absolutely no risk purchase of CD's?  Black box as in it is impossible for you to assess with a high degree of confidence what is going on with the issuer, the terms of the issue, and the financial strength of the insurer.  It's more of an overall odds thing.  As in historically, very few municipalities have defaulted on their payments etc.
lou   |     |   Comment #11
Interesting post. One correction: whether you pay a premium or discount for a bond is predicated much more on the bond's stated rate vis a vis the market rates for comparable bonds. You will not have to necessarily pay a premuim if the bond is going to mature in the next five years. For example, if the stated rate for the bond is 5% and the market rate is 3% then you will pay a premuim for the bond. I agree with the previous poster it is hard to believe that those sanitation bonds are yielding 5% today. I would like to see the CUSIP # as well.
lou   |     |   Comment #12
One last point - I know that municipalities have an excellent track record for not defaulting, but I don't think history will be good guide for the future. Many states, particularly CA., are stuck with huge structural deficits and pension liabilities that many experts feel will come to a head in the near future. Unless the federal govt. bails them out and right now there is no public support for that, it is conceivable that states and other local entities will have no choice but to either default or pay some percentage of the interest payments. California has already used IOU's to pay certain obligations in the past and it isn't a far leap for them to apply this to bondholders. I have been tempted to purchase these bonds, but I worry about this unprecedented situation.

Also, most municipal bonds are very illiquid, and it is not easy to sell them into the secondary market. If you do, you may have to take a big discount to sell them. Therefore, you should plan to hold them to maturity.
Anonymous   |     |   Comment #13
Note that bond prices are really high right now, and many are saying we are in a bond price bubble. Buyer beware.
Anonymous   |     |   Comment #14
California school bonds are better to purchase.
Anonymous   |     |   Comment #15
Why California school bonds,....well, you know the teachers unions and the publick services unions of state employees, and city employees.  Teachers need a place to teach and their union will protect them, so .......they will need to keep the schools open.  Can you picture a city that has lost all of it's schools for kindergarden to high school.  So the school bonds are my favorite,....generally general obligation bonds, utx.....unlinited taxation on residents to fund the bonds,.....and finally the insurance policy against default,.....assuming the company will still be in business down the road. 

Some school bonds are not insured in California, eg. West Contra Costa school bond  (really the Richmond, Pinole, Hercules area)  This would be the riskier school district.  Also the Oakland school district as well,.......so many years ago the Calif govt. bailed out and took over to make solvent the under funded school districts of Oakland and Richmond.   The cities still need schools for the kids.

Can you picture a town with no schools,.....somehow these school bonds should stay solvent.  And Calif has an extremely high priority to fund schools and keep them open or take them over.

In california there was a school bond, school located up in the sierra mountains,.....it looked like a dot on the map.  Well, bonds were floated and the money rushed in to buy those bonds at 8.3% coupon.

I later talked to someone who lived in the area, and he said the school was very small with only less than 100 students,.....so that's probably 4 or 5 teachers and one principal only.   That bond was not insured. 

During the great depression about 25% of munies went defalult,....the rest stayed solvent.

During the 1970's the new york almost insolvency crysis, the bonds were trading for 26 cents on the dollar,....was gridlock of govt to cut costs and benefits until new york almost went bust.  Could this happen to calif general obligation bonds????????????????????    If so, the calif financial infrastructure would immediately collapse and the state would not function al all,......but on the other hand, if the money isn't there to pay the bond creditors, then the pockets are emply no matter what the emergency.  I think the new york situation in the '70's might be a history pattern to repeat,.....coming so very close to the total collapse, then pulling out of financial problems at the last nano-second.

So I am buying calif munies,.....well I could go for the very safe out of state munies like Texas which is very stable,...but since I need good income stream, the Texas coupon rate will be much much lower than california,....So I will buy what appears to be the safest calif munies for the higher coupon rate.

Here's an idea which should help,.....go to google, and type in muni defaults,......make it a favorite side to click on, then periodically read which bonds default the most, and in other states,.....soon you will get a feel for the situations at hand.   I like to buy individual bonds not bond funds, because the individual bonds will return my principal at maturity.  As I stated before, the great depressions, 75% of the muni bonds survived,.....that's better than a stock portfolio in the depression days.


scorpio,   signing off for today.

Anonymous   |     |   Comment #16
Great dialog from everyone on this subject. I'm sure all of you will have more stories about the equity market!

One major point most people do not understand about holding bonds (not zeros) is the bond-yield curve - Bond valuation is inverse of interest rate at any point in time and the principle will adjust accordingly. So, you make more money when you buy a bond a hold it through a declining interest rate environment verses buying it during a low interest rate time frame. If you hold it to maturity, you will always get the rate irrespective of interest rate changes. If you decide to sell later and the rate is above the one you have the bond at, you will loose principle.

So, with that said, buying on the secondary market may be "smart", but you still have rising interest rate "risk". In my opinion, we are at the lowest point in history for interest rates and they only have one way to go - UP. Perhaps you have a year or two - but it will happen. Therefore, I would stick with a short term CD or longer term CD with a 3 to 6 month penalty verses buying bonds that have maturity greater than 5 years.
Anonymous   |     |   Comment #17
Richard #2 - not only are you an idiot but you cannot spell.
David   |     |   Comment #18
I differ with the author on several accounts.  I prefer to buy bonds in larger pieces.  The larger the piece, the better the bid if you need to liquidate the position.  I prefer to avoid insured bonds.  I want bonds from issuers that are strong enough to stand on their own two feet.  For me that means high grade - AA or AAA - general obligation bonds issued by a state, county, city, or school district.  I am extremely selective about revenue bonds and avoid special purpose or industrial revenue bonds.  I am willing to sacrifice yield for the additional safety of unlimited taxing authority.  

Zero coupon bonds save me the trouble of reinvesting the coupon payments.  Also, I know the true yield at which those coupons will be reinvested for the life of the bond.  The price volatility is higher, but the convenience factor is also higher.

Since I buy high grade GO's, I prefer the new issue market.  Most GO's are sold via competitive bid and the margins are very thin for the high bidder.  Bidders want new issue market share and they cut their margins to get it.  The hard part is getting access to new issues.  Revenue bonds are a different story; they are generally negotiated deals and have much fatter margins for the underwriters.  Any bond investor should make good use of investinginbonds.com or FINRA.  You need to get the CUSIP for any issue you are looking at, so that you can use these sites to get fresh trade data.  It is perfectly acceptable to show your broker a bid for whatever bond you have interest in.  You do not have to accept their offering price.  You may not get the bonds, but you may avoid getting your face ripped off.

I do agree with the author about bond funds.  I like the clarity of terms of individual bonds - the maturity date, the interest rate, the rating, etc.  The way some of them quote yields can be confusing and misleading.  Funds do have the advantage of better information and much more attention from the major dealers.

IMO, now is not a good time to reach for yield.  Rates are very low and I am quite concerned that when the economy does improve the extremely dovish Bernanke will be too slow to reduce excess liquidity and inflation will take hold.  Yields could rise rapidly and bond values - especially longer maturities - will suffer. 
lou   |     |   Comment #19
David, I know it has been a couple of months sinced you last posted here, but you seem to be very knowledgeable about purchasing bonds. I have been tempted to buy BAB's California GO bonds maturing in 2020 and yielding between 5.6% to 6%. Would you trust Ca. Go bonds at this time and do you think the yield is good considering that rates may go up in the future? Hopefully, you checked the email alert and you will see my post.
lou   |     |   Comment #20
I noticed that the comments are out of order. In my previous post, I was referring to post #18. I would welcome any other posters who would like to respond to my questions.
Muni Trader
Muni Trader   |     |   Comment #21
The author's information is incorrect in so many ways it would take me all day to go over each line but here are few problems: 1) There are no "huge incentives" for new issue bonds.  The commissions on new issues are regulated into the deal from the investment bank and the city or state.  In fact a broker usually (90% of the time) makes more on the secondary market. 2) Insurance means very little to nothing.  The muni market is so large that if any major defaults were to happen at the same time the insurance companies could never pay even 1% of the claims. Insurance is useful in single small defaults only - waste of money that brings down yield.  3) Orange County investors did get every penny back plus interest. This had nothing to do with insurance however. 4) Bond funds do make sense for the smaller investor (like the author) who could never be fully diversified. And with the crap this guy is buying he would be much safer in a fund.  A manager is buying 1,000s of issues and if he has a default the investor will never notice because it's .001% of his holdings.  This guy has 1 default and he immediately loses 20%-40% of his portfolio.  Not safe especially since he has NO idea what he owns. 5) Revenue bonds don't make a bond safer.  It's the source of the revenue of source of the tax base that matters.  California and Illinois are the 2 biggest pieces of crap states in the country.  Wake up!
Wealth Manager
Wealth Manager   |     |   Comment #22
^^Muni trader is absolutely right.  The risks inherent in individual purchase of small quantities truly outweighs the risks of volatility in the bond funds for smaller investors.  Plus, the second you come to offer (go to buy) on 10K of an issue, a huge markup is applied.  The larger the order, the better the pricing.  There are occasions where you can’t even buy a bond in lots less than a certain face amount.

I think the article is a good talking point, but not entirely accurate. Cheap also doesn't mean value.  If you are buying paper below par, the market is pricing in certain risks and of course, if you don't understand the mechanics of pricing, you can never be certain that you are paying for the right level of risk you are looking for.

The moral of the story- Since the FI market is now at the end of a 30 year bull market, rates have no where to go but up. Bernanke came out and told the world that the US will artificially keep rates low to 2013.If you have less than 100k, invest in different duration muni bond funds.  Allocate certain percentages of your money according to the risk level you fall into.   EX- 20% in durations of 10, 50% in duration of 4-7, 40% short duration/  This will diversify your income stream, volatility and interest rate risk. 

Remember, when rates go higher, the longer duration bond prices get push lower to become attractive to the market. Ex- If rates are 5% and you are holding a bond paying 3%, do not be surprised if the value of your bond is 17% lower.  If it is a bond that is 7 years or out, you have just "married" the bond.

Anonymous3   |     |   Comment #23
all i know is that 35 percent of my portfolio is in bonds or bond funds an i am doing okay
Wealth Manager
Wealth Manager   |     |   Comment #24
It's all relative to your risk tolerance, time horizon and the ability to reearn money in case of a catastrophic loss.  That means you are probably in the Moderate risk tolerance. Make sure the duractions are shorter and not longer than 6-7 years.  Also, corporate bonds have a high correlation to the stock markets.  So if you are over exposed in high beta assets, you will have a higher standard deviation/volatility on your portfolio.