Adventures in Municipal Bond Investing

Article from: InPeters Township Community Magazine: Industry Insights

December/January 2011

My favorite Bond is James Bond 007, the character known for driving fast cars, seducing beautiful women, preferring “shaken but not stirred” martinis and indulging in a never-ending affinity for high risk living. James Bond lives on the edge, but in contrast, municipal “bond” securities (a.k.a.-Munis) are often considered to fall into the low risk category. Note that the term “low risk” does not mean “zero risk,” and even an international spy with a high risk tolerance should carefully consider any security before investing. When you invest in a municipal bond you are actually lending your money to a federal, state, or local government. You receive periodic interest payments on your investment either monthly, quarterly, semi-annually or annually. At maturity, when all of the interest has been paid, your initial investment is returned. This seems straightforward, but there is much to consider before deciding to invest.

First of all, it is a good idea to match your financial goals with the maturity of a municipal bond issue. Again, the maturity of a bond is the point in time that the principle is paid back to an investor after all interest has been paid. Matching your financial goals with maturity is important because prior to this, a bond may be bought and sold on major exchanges where prices fluctuate in response to a variety of factors including changes in interest rates. Holding a bond to maturity will result in a return of your initial investment after you have been paid the interest that was due. However, if you must sell the bond before maturity, your return can be diminished if the bond is sold at a lower price than it was purchased.

Bonds are also subject to inflation risk since returns have historically not kept pace with inflation in comparison to equities. This can be especially troubling to fixed-income retirees during inflationary periods. These individuals may be counting on their municipal bond interest to meet their living expenses only to find that their payments buy less and less as time passes.

The greatest risk when investing in bonds, however, is the possibility of default. Default occurs when the issuer of a bond fails to pay you back. This risk can be very real. A number of articles have recently warned investors about the risks of municipal bond investing and the dangers inherent in what they perceive to be a “bond bubble”. The concern is that many municipal employee pension funds for teachers, firefighters, police officers, and other state and municipal employees are under-funded. Such plans are primarily funded with taxpayer dollars and the issuance of municipal bonds. Thus, there is a possibility of default should these pension funds continue to languish.

All of these risks do not mean that municipal bonds are a bad investment if you are in a high tax bracket and looking for a solid income stream. It simply means you should be careful when purchasing these bonds. The federal government supports the states and municipalities by not taxing the interest earned on these types of bonds. If you purchase a municipal bond within the state in which you reside, the interest is also free of state income tax. This is very attractive to those individuals in a high tax bracket. The tax-equivalent yield on a municipal bond paying 5% interest, for example, is about 8.2% for an individual in a 39% federal income tax bracket. How do you determine the risks associated with investing in a municipal bond? Municipal bonds are rated by various organizations, such as Moody’s and Standard and Poor’s. You should look for an investment grade bond rating of “A” or better and remember to ask about the “underlying” rating since this is an indication of the quality of the bond itself. Sometimes the published rating appears to be higher due to some external factor such as insurance on the bond, but if you are looking for safety, it may be best to judge the bond on its own merits. Here is a list of bond types that are generally considered secure:

• General Obligation Bonds (“GOs”). These bonds are guaranteed obligations of an issuing state/municipality that are backed by local taxes.
• Revenue Bonds. Revenue bonds are supported by the income generated by various public service companies such as electric facilities, sewage facilities, or toll-roads.
• “Double-barrel” Bonds. The advantage of this class of bonds is that they have characteristics of both revenue and general obligation bonds.
• Build America Bonds- These bonds are state municipal bond issues subsidized by the federal government.

Municipal bonds are conservative investments (very boring for the James Bond type) that are designed for those investors who are in a high tax bracket looking for tax-exempt income. But even with this kind of investment, you should carefully consider the risks before investing. If you are still looking for excitement, consider hang-gliding, sky-diving, or maybe a shark