There is much uncertainty in the air these days about the state of the U.S. economy. Whenever there is fear about the direction of the U.S. stock market, oftentimes, investors shy away from equities, (stocks,) and a flight to quality, to the bond market takes place. Generally, investors choose U.S. Governments bonds, but there are other bonds out there that bear looking into at any point in our time, as a portion of a balanced portfolio. Municipal Bonds are one such bond category.
When you buy a stock, you are buying a “share” of the underlying company. Bonds are debt instruments. Therefore, you are actually loaning the issuing bond agency money needed for whatever project they need to complete. In the case of municipal bonds, you are loaning money to the underlying city or county so that roads can be built, for example, or for the construction of a new fire or police station, schools or any part of the infrastructure. Municipal bonds are also issued by a developer who needs the money to provide streets, curbs or gutters to complete his or her new development.
Muni bonds can be issued for almost any municipal project. How, then, do they differ from, say, corporate bonds or U.S. Government bonds? Here is where we need to differentiate among bond categories and take a look at what makes Municipal Bonds attractive to investors.
First and foremost, most muni bonds are generally “double tax-free.” This means that the INCOME earned from a muni bond is tax-free to the investor from his/her state and federal Income Taxes. There are some exceptions, however, so one needs to be sure if the muni bond you are considering is exempt from both state and federal taxes. Most individual muni bond investors buy the bonds for the tax-free income. If, however, you sell it before maturity for more than you paid for the bond, the capitol gain is NOT tax-free.
Municipal bonds are appropriate only for investors in high tax brackets. If you are in a low tax bracket, you can generate more income from a taxable bond. The tax-free status of muni bonds allows higher net-worth individuals to accept a lower yield because their tax bite lowers the income so substantially on a taxable bond, that a muni bond with a lower yield works out better for them on the bottom line.
If a bond pays a 5% yield, the bond-holder will receive $500 on a $10,000.00 investment each year. Generally, the payments are paid in two installments, one payment of $250 each six months on this particular investment. Muni bond blocks come in increments of $5,000. However, a $10,000 investment is generally the minimum investment as $5000 blocks are hard to come-by.
If you want income in each month of the year, check the maturity date of the bond; the month the bond matures is generally the month the bond pays, and six months later. For example, if a bond matures on 8/1/2010, on that date you will receive your $10,000 dollars back, in the above case. Until that maturity date, you will receive your payment on August 1st and February 1st. You may then want to buy other bonds that pay in January and July and so on, thereby receiving bond income in each month of the year. Most muni bonds are structured this way but there are exceptions so be sure to be clear about when your bond will pay.
Bonds are rated according to the underlying security of the bond. The highest muni bond rating would be AAA and insured by an insuring agency. Ratings drop from there to AA, A and so on. There are also Non-rated muni bonds. Generally the interest rate is higher as the rating goes down, so non-rated munis have the highest interest rate.
Does this make the lower rated bonds more of a risk? Of course. But, if the non-rated bond has good coverage on the underlying property, and if it is written on an area of, let’s say, high-valued homes with the homeowners’ property tax checks as the collateral, it’s doubtful that those homeowners will loose a multi-million dollar home by not paying their taxes. So, there are many cases where a non-rated bond makes good sense. Be careful here. If you buy non-rated bonds, you should have someone to advise you who knows the ins and outs of the muni market.
If you are buying muni bonds without the assistance of a trusted and experienced bond broker, you might want to consider only AAA insured bonds.
You don’t pay commission on bonds. The bond house buys the bonds in bulk and “prices them to the market.” Whatever the market will bear on a particular day is where the bond is priced. The “spread” paid to the brokerage firm is built into the price. Prices on bonds, as on most debt instruments, fluxuates in price in tandem with the U.S. Treasury bond yield.
Bonds can be priced at “par,” which means you pay exactly 100 cents on each dollar or $10,000 on a bond with a face value of $10,000.00. Since bonds are “marked to the market,” as we discussed, if the U.S. Treasury Bond Yield goes up, the bond price will go up making your effective yield lower. What? Let’s explain this:
Think of yield as “what you GET for what you PAY.” Think of two kids on a teeter-tooter: When they are eye to eye, level with each other, consider that par, or even to the face value on the bond. In our above example, you are paying exactly $10,000 and you are yielding to maturity, 5%. But when the child with the dollar sign goes up, the other kid, the yield kid, goes down, and vice versa. So, if you pay more than 100 cents on the dollar, your yield is actually LESS than the yield on the face of the bond. If you pay less and buy the bond at a DISCOUNT, say 99cents on the dollar, you are actually yielding to maturity MORE than the face value on the bond.
From the above example, be skeptical of someone telling you that, for example, in today’s market, they bought a Muni Bond yielding 7.5%, when the average muni may be yielding 5% at par or 100 cents on the dollar. The yield on the face of the bond may be 7.5% but they will have paid a premium or over 100 cents on the dollar for the bond. Their effective yield or yield to maturity is nowhere near 7.5%; in fact it will be much, much lower. The other possibility for your friend, who actually DID get 7.5%, is that either the bond he’s buying is in danger of default or it isn’t completely double tax-free. There is no free lunch on Wall Street; not even in the bond market.
If you are in a high tax bracket, muni bonds in your portfolio, state and federally tax-free to you may be a beneficial part of your portfolio.