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Can You Benefit From Muni Bonds?


Can You Benefit From Muni Bonds?

The following is the third of a series of weekly articles in which Sheryl will provide overviews of investment options that offer alternatives to bank accounts. Last week's article covered dividend stocks. As with any investment that's not an insured deposit account, there are risks. Some may feel that these risks are worth it for the chance of higher yields. The focus of these articles will be on conservative investments that may appeal to some savers who want a chance of higher yields and minimal risk.

There’s nothing flashy about municipal bonds. In a nutshell, they are debt securities issued by states, cities, counties and other governmental entities to finance capital projects, like airports, schools and highways. There are roughly 44,000 issuers of municipal bonds and over 1 million different bonds trading with a face value of about $3.7 trillion, according to Mike Nicholas, CEO of the Bond Dealers of America.

Simply put, if you buy a muni bond you are lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or "principal."  The date when the issuer repays the principal, the bond’s maturity date, may be years in the future.  Short-term bonds mature in one to three years, while long-term bonds generally will not mature for more than a decade.

While muni bonds may be plain vanilla in a world of exotic investments, that’s not to say they aren’t worth a look-see. They have some advantages.

Nicholas highlights some of them, "Historically, municipal securities have had significantly lower rates of default than corporate and foreign government bonds," he says.

Additionally, for a century, the interest income on most muni bonds has not been taxable. The tax status of muni bonds allows states and municipalities to issue bonds to investors at much more affordable interest rates. Muni bonds benefit from the security of a broad tax base, or a defined revenue source. Nicholas explains that the cash flows to make interest payments on a "general obligation" municipal bond are collected through a state or municipality’s ability to tax. Tax revenue can come from a variety of sources, including sales and property taxes.

"Municipal bonds are ideal for a buy and hold investor looking for steady cash flow and extremely high likelihood of principal repayment," says Nicholas.

Because typically municipal bonds have had very low correlation to other assets classes, such as equities and Treasuries, they can be effective portfolio diversifiers, points out Stephanie Larosiliere, client portfolio manager for Invesco.

What you need to know

Like all investments, there are risks, downsides when you invest in muni bonds or muni bond funds.

"Just because a municipal bond is insured does not mean it is without risk. The price of an insured muni bond will still fluctuate with interest rates, as well as with the overall muni bond market. They also still carry credit risk. The insurance is only as good as the insurance company backing up the guarantee. Take a close look at the insuring institution, and check the underlying bond rating as well. The underlying bond rating is the rating of the bond on its own without the insurance factored in," advises Curtis Chambers, a certified financial planner with Chambers Financial Group.

Credit worthiness of the issuer is critical with municipal bond insurance being dramatically reduced in the aftermath of the financial crisis.

Credit worthiness of the issuer is critical with municipal bond insurance being dramatically reduced in the aftermath of the financial crisis. "Because of this, most investors are probably best served by utilizing municipal bond funds offered by reputable fund companies," says Graig Stettner, a financial advisor with LPL Financial.

Municipal bonds are not ideal in a rising interest rate environment. An investor who invests prior to rates rising will lose out on yield they could have earned if they waited to invest at higher rates, says Nicholas.

Secondly, because bond prices move in the opposite direction of bond yields, investors will suffer market-to-market losses on their bonds in a rising rate environment. But, due to the extremely low default rate and steady interest payments, and because most investors hold their bonds to maturity, these losses are rarely realized, says Nicholas.

‘It always amazes me to hear family members and others proclaim surprise and shock when they open their statements and their ‘safe’ tax-exempt muni bond lost value during the preceding period. After buying a fixed rate bond, your fixed rate is compared every future day to the fixed rate available on the same bond. If the market rates go higher after you buy, your rate isn’t as attractive as it was when you bought it and therefore the value of your bond goes down," explains John Payne, a registered municipal advisor.

However, if you sell before final maturity, you are subject to the then value per the markets. For example, if you buy a 10-year bond for $100 and the coupon interest rate is 3% annually, and you sell it two years after purchasing, eight years before final maturity, and, most importantly, when the eight-year rate in the marketplace for that bond would be 5%, don’t expect to get $100 back. Your bond lost value because rates climbed and your 3% just isn’t enough to entice anybody else to buy your bond, so you will sell at a discount to make up for the difference, says Payne.

On the contrary, if rates go down, or simply as a matter of time passing, your value will go up in a normal interest environment. "Buying with the intent of holding to final maturity is wise for retail buyers," says Payne.

All bonds are not created equal

Certain types of bonds are much more price volatile than others if sold prior to final maturity, such as zero coupon bonds, which are bonds sold at a large discount that don’t pay periodic interest. "Be sure you understand what you are getting if you intend to buy this type of bond. Bonds of this nature also include capital appreciation bonds (CABs), which are popular in many states," says Payne.

Know too, that not all muni bonds are exempt from tax, cautions Stettner. Usually interest received from bonds issued in other states is subject to state income tax, he says.

Stay informed

Periodic disclosure information, including financial reports and other material event notices are posted on a regulated website called EMMA, www.emma.msrb.org. You can look up your specific bond and locate periodic disclosures. This is useful to follow the general fiscal health of the municipality and become aware of any specific matters that may affect the value of your bond now or in the future. If credit conditions deteriorate, your bond may very well lose value, or worst case, may someday be subject to payment default, says Payne.

Be strategic

Investors should consider building a laddered structure of municipal bonds by utilizing target-date Exchange-traded funds (ETFs), which invest in bonds due in individual years. "This adds some certainty to one’s maturity structure vis-à-vis an open-end mutual fund," says Stettner.

Individual muni bonds or muni bond funds, as a rule, should not be held in a qualified retirement account. The interest loses its tax favorable status, says Michael Cice, registered principal with Allied Financial Consultants.

"Don’t forget Unit Investment Trusts (UITs) are also a good way to invest in municipal securities," adds Cice.

History is mostly favorable when it comes to municipal bonds. According to Jay Sommariva, vice president and senior portfolio manager of Fort Pitt Capital Group, "Throughout time, municipals have been a sound alternative in most fixed income portfolios with either institutional investors’ strategies or retail investors’ plans."

Editor's Note:

For additional information on muni bonds, please refer to the article "What Your Broker Won't Tell Your about Municipal Bonds." This was written by a reader who had graciously offered to share his experience in muni bonds.

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Comments
Anonymous
Anonymous   |     |   Comment #1
I did munis for a large number of years, made quite a lot of money, and never lost a dime.  I stopped with munis prior to 2008-2009, and went back to CDs.  Sure am happy I got out of munis when I did.  
Anonymous
Anonymous   |     |   Comment #2
I have individual muni's and am very happy.  None of the bonds I own have defaulted.  They are triple tax free and I live in NY.  They rarely default and my old issues also have insurance.  You have to do research to avoid troubled bonds  Keep away from distressed bonds such as PR and Detroit.  If you buy a muni fund check on their exposures to risky bonds such as to those of Puerto Rico.  I have many bonds that are paying 5% and are not callable until 2020's.  I have one bond that pays 5.75% and is not callable until 2019.  Right now the muni market is expensive so I haven't bought any recently.   It is a part of my portfolio diversification.
Anonymous
Anonymous   |     |   Comment #3
Good article---
Puzzled by #1 comment --"Sure am happy I got out of munis when I did"--
some of the best muni purchases I ever made were during that period. 
I have many individual munis and some muni bond funds--since I have always
held my muins to maturity I never cared about price fluctuations(really good to
ladder approach)--yields have been far better than any taxable investments that
I would ever consider.  Also own many, many CD's, corporate bonds and dividend
paying stocks---each have their own place and fulfill different needs....to not be
willing to look at all available products seems to be self-cheating.
Incidentally, munis have the lowest default rate second only to governments.
Thought that Comment #2 was right on the mark..
Anonymous
Anonymous   |     |   Comment #4
Finally after 6 long long years you are talking about these!!! I got into them in 2013 in the sell off of bonds when the 10 yr was 3% and the premium on munis was 5-7% on AA and AAA rated bonds.. not that the 10 yr is 1.81, you willpay a premium of almost 20%!! That means if you want 100K in muni bonds with a 5% coupon payment for 20 yrs you pay 120K...still worth it as far as Im concerned because you pay no federal taxes and at this premium it would takes 3 1/2 yrs until youbreak even and anything form that point on it clear interest..I take 9-10 calls and no less so I take 2023 and 2024 calls on 15-20 yr bonds....see a professional who sells all bonds not just their inventory of bonds..
lou
lou   |     |   Comment #5
You make some good points about muni bonds but I haven't liked them for many years. At my age (63) I am not willing to buy a 20-year muni bonds at a 3% yield-to-maturity. If we ever experience inflation again and interest rates climb to levels seen in the 1970's through the 90's, then those interest payments won't seem particularly attractive.

Muni bonds are notoriously illiquid investments. They would be very hard to unload at a fair price in a rising interest rate environment. I also worry about the unfunded pension liabilities of many states and municipalities, which I think can influence the price of their bonds sometime in the future.

Although muni buyers can boast now because interest rates have continued to decline, that can change fairly quickly in the future. If that should happen, I can promise you we won't be seeing posters on this site bragging about about their muni bond portfolios.

I could be a buyer of municipal bonds but not at these prices.
Anonymous
Anonymous   |     |   Comment #7
I think you are right about this, but the question is when interest rates rise.  So when do you think that is going to happen?
lou
lou   |     |   Comment #8
The million dollar question! I wish I knew.
Anonymous
Anonymous   |     |   Comment #6
I'm old enough to remember the days when, as you state, one paid no Federal tax on income from munis.  I did that a lot in the old days.  I had to.  But that was then.  This, my friend, is NOW.  And today things are different.  In 2015 one easily can incur Federal tax as an outcome of owning municipal bonds, and the problem grows worse with each passing year.

Heck, I'm old enough to remember when America was a wonderfully free country.  I really enjoyed all that freedom.  But truthfully I took it for granted, never dreaming it would one day evaporate and be gone.  It's a good thing young Americans today never have actually experienced such freedom as once existed here.  They would be really ****ed off if they realized the extent to which they've been shortchanged.  
Anonymous
Anonymous   |     |   Comment #9
No one has to pay federal tax on municipal bonds unless the particular bond  is subject to the Alternative Minimum Tax.  That could change in the future but so can any tax law.   I pick bonds that are not subject to the AMT.  Most state and local governments exempt bond interest (I believe Kentucky taxes muni interest) if you buy bonds from issuers within the state you reside.  For someone who is 63 buying a long term bond may not make sense.   Muni's are not for everyone and are a bond.  The value will go down if interest rates go up.  You may lose capital if you cash out before the bond is due .  If rates go up most bonds have a call option that on a specific date (usually 5 -10 years out)  in the future and usually annually after that date the bond can be called if rates are low.  Some older bonds would pay a call premium. (Usually $1 for each 100 of bonds) if the bond was called.   I have not seen many bonds with that feature lately but had a bond called that had this feature.
lou
lou   |     |   Comment #10
If rates go up, none of these call options will get exercised. In that scenario you will hold the bond until maturity.
Anonymous
Anonymous   |     |   Comment #12
If you have to sell the bond for some reason you can lose capital. Right now some of my 5% bonds are being called.  Rates go up and down over years.  When the call date of the bond comes if rates are lower than your bond is paying the issuer will most likely call your bond. No one knows what the future holds.  You must make decisions that you are comfortable with and the best for your circumstances.  I would recommend a bond ladder
Anonymous
Anonymous   |     |   Comment #11
PS Bonds from Territories of the US and Puerto Rico are tax free if your state does not tax muni bonds.  I would keep away from PR bonds as they are risky
Anonymous
Anonymous   |     |   Comment #13
Sorry my friend, it's not just about the AMT as you state.  Some of the SS impact is discussed here:

http://www.schwab.com/public/schwab/nn/articles/Municipal-Bonds-When-Tax-Free-Isn-t-So-Free

But that's an older writing.  There is more degradation today, I think.  No time to research.  And even if it's only SS and AMT right now, there will be more impact coming up.  For Congress and Obama, munis are simply too juicy a target to pass up!  With America now over $18T in debt, wealthy muni owners today have bull's eyes on their backs!  
Anonymous
Anonymous   |     |   Comment #14
Quote from your post "I'm old enough to remember the days when, as you state, one paid no Federal tax on income from munis.  I did that a lot in the old days."

Most people do not pay federal income tax on Muni bonds.   I did not realize that it affects Social Security Benefits.  Your statement should have noted you were discussing Social Security and AMT affects 
Anonymous
Anonymous   |     |   Comment #15
Acknowledged.  Well, perhaps you're right.  I honestly no longer know for certain;  it has been too long.

Back in 2008-2009, when one or two of the muni bond insurance companies upon which I once had relied, became shaky, I was doubly glad not to be in munis.  But truth is I had exited long before.
  
Thinking back, it always bothered me when the IRS demanded to know the amount of my muni bond income each year.  My (erroneous) reasoning was like:  Hey, the interest is not taxable, why should you care and why should this be any of your business!!  Yeah, I realize today that was really naive.  Live and learn.  I'm pleased to be out;  I don't need that kind of risk coming from a couple of directions at once.

I can even remember, perhaps fifteen or more years ago, listening to Bob Brinker telling listeners it was no problem buying California GO's.  I never bought a California muni in my life, and I bought lots of them over the years believe me, both taxable and non-taxable.  Anyway, you don't hear Bob offering that same counsel today.  It was not munis.  But when the government became involved in the GM bail out, bondholders got hosed.  It was all politics.  If Cali ever went down it would be the same sort of thing IMHO.  Heck, I don't think even wealthy Orange County made good on their default.  Time passes, people forget, life goes on, and new suckers lose out years later.  That's the American way!!
Anonymous
Anonymous   |     |   Comment #16
All investments have risks.  The amount of munis that default is very small.  even a CD has risks.  If the bank fails the FDIC may pay you out or the new bank may lower your interest rate.  One has to have a diversified portfolio.  Your right that the government can change the ruls at any time.  If you have major bank failures and the FDIC does not have the funds to pay depositors what will they do?  Look what happened in Cyprus. 
Anonymous
Anonymous   |     |   Comment #17
Have after tax assets!  Bank of Mattress is "one" option...especially if no debt, minimal expenses, nice SocSec payments, etc.
Anonymous
Anonymous   |     |   Comment #18
Let's see if we get to negative rates like the Swiss -.75%
Anonymous
Anonymous   |     |   Comment #19
At current rates of inflation, your FDIC short-term savings are already losing value. In other words, your return is negative. I know someone with 50K in a basically 0% account because they cannot afford stock market risk, are not Internet savvy and local CD rates are truly dismal.