Municipal Bonds
Municipal Bonds (called Munis for short) are issued by second and third tier local government to finance the building of public infrastructure, such as highways, libraries, sewerage works, and schools. The big plus point of Munis is that all the income from the bond is free of federal tax, and if you live in the state issuing the bond, free of state tax, and if you live in the city issuing the bond, free of city tax. Eg NYC Municipal Bonds are triple tax exempt when purchased by a resident of the city. So always double check that your home address qualifies you for the tax breaks when buying Munis.
Munis are just one step down from Treasuries in terms of security, and so after allowing for the tax concessions with Munis, typically Treasuries and Munis are priced pretty similarly. So Munis tend to be especially attractive than Treasuries for high-income investors looking for no-hassle tax-free income.
There are two main types of Municipal Bonds. The first is General Obligation Bonds. These are guaranteed by the ‘credit and taxing power’ of the local body issuing the bond. The second is Revenue Bonds which are issued for a specific project, and backed by the predicted revenue stream for the project. So General Obligation Bonds have a better intrinsic guarantee, and are less risky than Revenue Bonds. You may come across other types of Munis, such as housing bonds, tax bonds, floater bonds and lease revenue bonds, but make sure you completely comprehend the nature of these more esoteric offerings before investing. Also some bonds are described as Private Purpose meaning they support a project whose funding is partly privately financed. Again investigate further before committing to these, as the great tax breaks of Munis may not apply here.
When you invest in Munis, you should be aware of the risks associated with this form of investment-
Firstly there’s the credit risk. As with all bonds, this cannot be considered to be absolutely zero. For instance in 1995, investors in Orange County Munis lost over $1.5 billion when the county filed for bankruptcy, after the state refused to pitch in with any rescue package. The OC fiasco was due to a pretty rare set of circumstances (mainly thanks to a public finance manager who made wild decisions well beyond his remit). Other famous cases include WPPSS’s (Washington Public Power Supply System) default on $2.25 billion in General Obligation bonds, after a project to build 5 nuclear power stations collapsed after just 1 had been completed. The ratings agency Moody’s gives ratings to Munis, from AAA for high quality bonds, down to D, to those in default.
Secondly there’s interest rate risk. Interest rates may rise and any new bonds issued will pay a better rate than the existing ones. But the converse is obviously also true. Interest rates may well fall, leading to an increase in value of your bonds.
Lastly (not applicable to most bonds) consider call risk. Any Muni may have what’s termed ‘call provision’, meaning the bond can be redeemed by the issuer early. This would happen if interest rates became super low, meaning it would be difficult to re-invest the funds at a similar rate to the terminated bonds.
It’s difficult to give general advice on Purchasing Munis, because by the very nature of the bonds, the range availabe differs from location to location. One of the best options is to keep an eye open for new issues in your local press. Alternatively contact a local broker who will detail the options available.
When buying bonds you can purchase individual bonds, or go for a collective fund, such as a mutual or ETF. Individual Bonds generally come with maturities of 5, 10, or 20 years, with a minimum investment threshold of $5000. Commission of buying individual bonds is around 0.5% and 1%, relatively small when weighed against the lifetime of the bond. No further management charges etc are applicable. From then on you’ll collect the interest payments, and when the bond matures remember to present it to the issuer for repayment (in general they will not pay you automatically!). You can also sell your bond early through a broker (it’s value will depend on its coupon and length to maturity). Collective funds such as mutuals or ETFs are normally broken down by state to ensure the tax free benefits are still available. These funds allow you to invest smaller amounts, and spread your risk over several different bonds. But purchasing commission, buy-sell spread, and annual management charges can take a big bite from your money.
For further interesting reading on Munis see Municipal Bonds – A Conundrum and Are Municipal Bonds the Next Shoe to Fall.
Best Finance’s (from 100BestEverything) ratings for Munis: Security: 5 stars out of 5. Costs 5 stars out of 5 (when bought direct). Flexibility 4 stars out of 5.
