Originally Posted: May 2009
Revised: May 2011

Revised Municipal Bonds article to reflect some updates:

Recovering from the recent economic & market collapse is not going to be a simple task for many people.  In addition to the vaporization of Trillions of dollars, the recent collapse has instilled extraordinary fear in most investors.  It is no surprise that the current panic has led investors to accumulate nearly $10 Trillion dollars in cash or equivalent holdings that are currently sitting un-invested on the sidelines, waiting for better times.  With savings accounts, CDs and Treasuries only yielding a [taxable] average of approximately 2.3%, it would take almost century to get back what many people lost… literally!

For investors who are not yet ready to invest back into the equity side of the market, don’t worry, this article is not going argue that point.  In fact, all I will do today is show you that if you are currently interested in the preservation of capital, you should continue to do so, but consider that there may be a more effective way.  This specific article was written to help educate our clients on the basics of Municipal “Muni” Bonds.  This should give you better idea of what Municipal Bonds are, so that [together] we can make a more well-informed decision as to whether or not Muni Bonds would be useful tools in mapping out your personal financial strategy.

█ WHAT IS THE BASIC DEFINITION OF A BOND?

In the world of finance, a bond is simply a type of loan that the issuer (public authorities, credit institutions, companies, etc.) owes to the holders (institutional & individual investors). Investors are technically loaning money to an entity when they buy its bonds. Along with paying the principal back at a later date (maturity), the issuing entity is also obligated to pay interest payments (coupon) at predetermined intervals (usually semi-annually or annually).

Although bonds and stocks are both securities, bond holders are senior to stocks holders and most other creditors in the case of a default.  A major difference between the two is that bond holders are lenders to the entity, whereas stock holders are the owners of the entity.  One of the major factors that make bonds more conservative than stocks is that they can still recover some or all of their principal investment in the event of an entity’s default, whereas stock holders are most likely at an absolute loss.  Default statistics from a recent study conducted by The Municipal Bond Fairness Act on September 9^th, 2008 are shown on the next page.

Bonds can vary significantly based on the terms of the bond’s indenture—a formal debt agreement outlining the characteristics of the bond. Because each bond issue is different, it is important to understand the terms before investing.

█ WHAT IS THE BASIC DEFINITION OF A MUNICIPAL BOND (MUNI)?

A Municipal Bond is a bond issued by a city or other local government or agency (i.e. cities, counties, public school districts, public healthcare facilities or airports etc.).  They are issued for the purpose of raising capital for infrastructure or other purpose projects when these entities cannot or do not wish to pay immediately with readily available funds.  When you buy a municipal bond, you are lending the money to the issuer in exchange for a predetermined interest payment along with a commitment to receive your principal back at the maturity date.  Interest income received by holders of municipal bonds is often exempt from all Federal Income Tax, State & Local Income Tax of the state in which they are issued.  This is the reason why Municipal Bonds are more advantageous to individuals with high incomes rather than lower incomes.  The tax exemption of many Municipal Bonds can potentially provide higher absolute returns than tax deferred investments made in Qualified Retirement Accounts (401k, IRA’s, Annuities etc.).[1] Either way, if the primary investing objective is to preserve capital while generating a tax-free income stream, Municipal Bonds can be one of the best options available.

When making an investment in Municipal Bonds, investors must make sure that they are aware that some Municipal Bonds are taxable and subject to Alternative Minimum Tax (AMT).  The taxability of a bond is determined by the type of project that is being funded by the issued bonds.  I am personally a licensed Municipal Securities Principal and have a team of experienced Financial Advisors on staff.  Knowledge, experience and access to many markets and tools are critical when dealing in the Municipal Bond Market.

MUNICIPAL BONDS CAN COME IN THE FOLLOWING TWO VARIETIES:

1. General Obligation Bonds (G.O.)

2. Revenue Bonds (REV)

General Obligation Bonds “G.O. Bonds”, are a common type of Municipal Bond in the United States, and are secured by the municipalities pledge to legally use available resources, such as tax revenues, in order to pay back the bond holders.  G.O. Bonds pledges include a pledge to levy Property Tax in order to meet the debt owed to Bond holders.  In the case of taxpayer delinquency, the General Obligation requires the municipality to pay the debt owed to bond holders out of its available resources.

Revenue Bonds are issued to fund revenue generating infrastructure projects, such as Toll Roads, Bridges, Tunnels, University Dormitories, Water, Sewers, Airports, Power Plants and Prisons.  They differ from G.O. Bonds because they are guaranteed solely from the revenues generated by the associated project that has been funded by the bonds.  Taxes, tolls and fees generated from these facilities ultimately pay off the bond holders.  Revenue Bonds issued to fund education and school systems are generally backed by income or progressive taxes.

Both types of bonds are often tax exempt and are particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts.

█ WHAT ARE SOME REASONS PEOPLE INVEST IN MUNICIPAL BONDS?

In general, Municipal Bonds could be a part of every well diversified portfolio.  As of December 31^st, 2008 the total outstanding state and local debt obligations was nearly $2.7 Trillion[2].  Age, financial condition and objectives are just some of the factors that our advisors consider when they determine how you would be able to take advantage of Municipal Bonds.  If the investing objective is to preserve capital while generating a tax-free income stream, municipal bonds can be a very distinguishable choice.

Preservation of Capital: Since Muni Bonds are debt obligations issued by government entities the likelihood that the issuer will repay their debt back to the holder is often greater than other comparable investments. This often makes the credit risk of Muni Bonds considered better than other comparable investments.   According to a study published in The Municipal Bond Fairness Act on September 9^th, 2008 the historical default rate of all Municipal Bonds reported by Moody’s and the S&P is only 0.10 and 0.29%  respectively {0.001 and .0029}.  High Investment Grade bonds have an even more impeccable track record.  A comparison of Municipal Bonds to Corporate Bonds is shown on Table A.[3] In addition, investors should also realize that even in the circumstances of defaulted municipal bonds, the historical average recovery rate is 66% of the face value.

 

TABLE A
CUMULATIVE HISTORIC DEFAULT RATES [In percent]
	Moody’s		S&P
	Muni	Corp	Muni	Corp
Aaa/AAA……………………	0.00	0.52	0.00	0.60
Aa/AA……………………….	0.06	0.52	0.00	1.50
A/A…………………………..	0.03	1.29	0.23	2.91
Baa/BBB…………………….	0.13	4.64	0.32	10.29
Ba/BB………………………..	2.65	19.12	1.74	29.93
B/B…………………………..	11.86	43.34	8.48	53.72
Caa-C/CCC-C………………	16.58	69.18	44.81	69.19
Investment Grade……….	0.07	2.09	0.20	4.14
Non-Invest Grade……….	4.29	31.37	7.37	42.35
All………………………..	0.10	9.70	0.29	12.98
Source. Moody’s, S&P.

 

One of the things that we have all learned during the market collapse of 2008 is that the idea of “too big to fail” does not always apply.  Although Certificates of Deposits and other Bank deposits are considered safe investments, investors must realize that in the case of a bank failure, the FDIC insurance limit is normally $100,000 per bank—the $250,000 FDIC insurance limit that was passed in 2008 is currently considered temporary.  So a $400,000 CD would be in jeopardy in the case of a bank failure under the current insurance limits provided solely by FDIC.  In comparison, Muni Bonds are usually held at Member FINRA broker dealers, most of which is required to carry SIPC insurance[4].  SIPC insurance at Reuven Enterprises Securities Division (or any other Member FINRA firm) is $500,000 per customer, with no more than $100,000 in cash.  For more information about SIPC, how it works and who are the member firms please visit their website at www.sipc.org.

To clarify, SIPC insurance versus FDIC insurance does not by itself make Municipal Bonds more conservative than CD’s and other Bank deposits.  In fact, there are many cases where the contrary is true.  This information is only to educate you further about intricate details of the industry, and is only pertaining to circumstances where the entity’s solvency comes into question (e.g. Bank failure[5] or Brokerage failure[6]).  Before the FDIC insurance comes into the equation, the bank has to fail, whereas the SIPC only comes into question if the brokerage firm fails.  The solvency of a municipality, not the brokerage firm, is guaranteeing the Municipal Bond, and the SIPC insurance would not come into effect if the municipality failed, but rather if the Brokerage firm failed. In the age where Too Big To Fail came into question, one must consider all factors when evaluating investments, and this is just another one to consider, not a determining factor.

Liquidity:[7] One of the most common misconceptions about Municipal Bonds is that they are like most other conservative, income-generating investments and “lock your money up until maturity.” This is far from the truth! Municipal bonds are LIQUID! This is actually one of the biggest advantageous that Muni Bonds have over other comparable investments.  You can buy and sell your bond in the open market.  In fact some professional traders make a very good living trading bonds on a short term basis.  Although the price may vary from day to day on bonds, with all things being equal, Muni Bonds are generally not viewed as volatile securities.  So even if you own a Muni Bond that matures in 20 years, you can sell it tomorrow if you and your advisor believe it would be in your best investment interest.  This is not to imply that day-trading Muni Bonds is a recommended practice, but I think you get the point.

Taxation of Muni Bonds: As it was mentioned previously, interest income received by holders of municipal bonds is often exempt from all Federal Income Tax, State & Local Income Tax of the state in which they are issued.  This is the reason why Municipal Bonds are more advantageous to individuals with higher incomes than lower ones.  Note that in the case the price of the bond increases, the gains on the principal amount are not tax exempt.  To put this in perspective and show you how to calculate the Tax Equivalent Yield consider this:

Tax Equivalent Yield = Muni Bond Rate as whole #/

(1-[ Federal Tax Rate + State Tax Rate])

8.77 % = 5 % Bond / 1 – [0.33 + 0.10]

Diversification: Whether you are a Growth oriented investor that is willing to take more market risk, or you are a more Conservative investor that is not really interested or able to absorb the market’s volatility, the investment of Municipal Bonds can be very valuable to you as part of diversifying your portfolio.  A growth investor that wants to mitigate some of the risk and volatility of his/her equity holdings can still have a large stake in the long term fruition of the public markets.  An example of this would be by allocating a 75% of his assets into the equities, while maintaining a 25% portion of his portfolio into High Grade Municipal Bonds.   If his equity holdings are down 30%, while the bond portion of the portfolio has stayed stable (i.e. flat) and generated a 5% yield, his portfolio would only be down 17.5 % rather than 30%, had the entire portfolio been in equities.

On the other hand, a conservative investor, that is unable or unwilling to deal with the market’s volatility, but still needs to generate a higher rate of return, can have the opposite allocation—75% Bonds, 25% stocks.  In the case the market recovers and his Growth portfolio is up 30%, while his Bonds stayed stable (i.e. flat) and yielded 5%, his overall portfolio would be up 12.5% instead of just 5% by only holding the Bonds.  Note that these examples are for illustrative purposes only, and are by no means taking your individual situation into account. Also consider the fact that municipal bonds do fluctuate in price, so the examples are extreme just illustrate a theory, and by no means are a guarantee against a loss or assurance against any price fluctuation.

The low correlation[8] between Bonds and Stocks makes Municipal Bonds another great tool when you are building a diversified portfolio[9].

█ WHAT ARE SOME BUYING STRATEGIES USED WITH MUNI BONDS?

There are many different types of Bond Investing Strategies.  They range from passive long term investing, to a more active approach that allows the investor to take advantage of market pricing along with the other benefits mentioned previously.  Buying municipal bonds is not like buying a CD, where the main concern is the higher yield.  In general, the higher the yield, the lower the grade of the bond, and the higher the potential risk is.   Under most circumstances, there are rarely any reasons to frequently trade Municipal Bonds, unless you are a professional.  But the fact that investors have the capability of doing so (i.e. liquidity) makes them one of the best asset classes available today.  

█ I OWN SOME BOND MUTUAL FUNDS, ISN’T THAT THE SAME THING?

Without going into every detail, the answer is simply NO! Although bond funds do serve certain purposes, there are several additional benefits that owning the actual individual Muni Bonds will provide that the bond funds cannot.  The first, in my opinion, is the fact that you know exactly what you own, rather than knowing about the top 10 holdings.  This type of transparency may not matter to most people, but again this is my opinion.

The second benefit is probably more popular—state & local tax exemption. If you own a bond fund, you probably own an extraordinary amount of bonds from across the country in that fund. Although this diversification may sooth the risk-averse investors in some ways, it eliminates the state & local tax benefit that many municipal bond holders are entitled to. A bond holder can only get the state & local tax exemption in bonds that are issued in the state he resides in.

Lastly, the cost benefits of owning individual bonds versus bonds through a fund. I know that this is probably the last thing you thought you would hear from someone that is in “the business”, but I guess you may have to get to know me to understand. When you buy a bond in a traditional commission based brokerage account, and decide to hold on to it for the long run, the onetime cost is minimal in comparison. In a fund, although you may not be getting a bill every month, I hope you do realize that the fund does charge management and other types of fees, even if you did not have a transaction in years. This factor may not affect all investors the same way, but if you compare the yields offered by some of these open ended bond mutual funds, you will find that some of them are actually offering only 3 or 4 % yields currently, whereas you can probably find an AAA rated bond that is offering 5.25% in some states. When you are working on large sums of money, along with such small percentages, that 31 – 75 percent difference makes a difference.

Also keep in mind that if you are in a fee based account, the circumstances can actually be even less favorable for you than previously mentioned.  But that’s another long argument you will find more details about in my next article “The Truth about Fees vs. Commissions.”

█ WHAT MAKES MUNI’S MORE LUCRATIVE TODAY THAN ANY OTHER TIME IN HISTORY?

Because of the additional state & local tax exemptions that Municipal Bonds offer over Treasuries (Treasuries only have the Federal Tax Exemptions), the traditional yields that Treasuries offer is historically much higher than Municipal Bonds.  In fact, the typical rate (i.e. yield) of Municipal Bonds is only 85% of the yield offered by a 30 year U.S. Treasury[10].  Not in this market!  As a result of the panic reactions of many investors, an extraordinary amount of money has been moved into U.S. Treasuries, driving up the price, and lowering the yield to as low as 2.6%.  In comparison, many AAA rated municipal bonds can be bought at or below par, yielding investors over 5%–nearly 100% more return, even if you exclude the additional tax benefits.  This has happened only a few times in the past, but not to such extremes.[11]

With many Treasuries trading at a premium to par[12], investors may be happy that they did not lose money during the 2008 stock market collapse, but if they decide to hold on to them for the long run (i.e. until maturity), they are practically guaranteed to lose money since they mature at 100 (i.e. par).  They may be “considered” the safest investments around, since they are guaranteed by the U.S. government, but if you include all of the factors, there may be a better way.

█ CONCLUSION

Although Municipal Bonds have not been the highest return generating investments throughout history, they were never meant to be.  The Municipal Bond market is nearly a $2.7 Trillion dollar market[13] with a low enough historical default ratio that has made them one of the safest investments available today[14].  They have helped many individuals and institutions mitigate the volatility risk that the stock market has, while offering tax benefits that are hard to compete with.  Wealthy Investors can benefit more from the tax exemptions, and smaller investors can preserve their capital while maintaining a respectable yield.  It is hard to argue with the fact that Municipal Bonds can be a useful tool to investors that are interested in a well diversified portfolio.

All the best,

Ron Reuven

President, CEO and Licensed Municipal Securities Principal

Risk Factors
While buying municipals bonds is viewed as a conservative investment strategy, it is not risk-free. The following are the risk factors;

Credit Risk: If the issuer is unable to meets its financial obligations, it may fail to make scheduled interest payments and/or be unable to repay the principal upon maturity. To assist in the evaluation of an issuer’s creditworthiness, ratings agencies, such as Moody’s Investors Service and Standard & Poor’s analyze a bond issuer’s ability to meet its debt obligations, and issue ratings from ‘Aaa’ or ‘AAA’ for the most creditworthy issuers to ‘Ca’, ‘C’, ‘D’, ‘DDD’, ‘DD’ or ‘D’ for those in default. Bonds rated ‘BBB’, ‘Baa’ or better are generally considered appropriate investments when capital preservation is the primary objective. To reduce investor concern, many municipal bonds are backed by insurance policies guaranteeing repayment in the event of default.
Interest-Rate Risk: The interest rate of most municipal bonds is paid at a fixed rate. The rate does not change over the life of the bond. If interest rates in the marketplace rise, the bond you own will be paying a lower yield relative to the yield offered by newly issued bonds.

Tax-Bracket Changes: Some municipal bonds generate tax-free income, and therefore pay lower interest rates than taxable bonds. Investors who anticipate a significant drop in their marginal income-tax rate may be better served by the higher yield available from taxable bonds.
Call Risk: Many bonds allow the issuer to repay all or a portion of the bond prior to the maturity date. The investor’s capital is returned with a premium added in exchange for the early debt retirement. While you get your entire initial investment plus some back if the bond is called, your income stream ends earlier than you were expecting it to.

Market Risk: The underlying price of a particular bond changes in response to market conditions. When interest rates fall, newly issued bonds will pay a lower yield than existing issues, which makes the older bonds more attractive. Investors who want the higher yield may be willing to pay a premium to get it. Likewise, if interest rates rise, newly issued bonds will pay a higher yield than existing issues. Investors who buy the older issues are likely to do so only if they get it at a discount. If you buy a bond and hold it until maturity, market risk is not a factor because your principal investment will be returned in full at maturity. Should you choose to sell prior to the maturity date, your gain or loss will be dictated by market conditions, and the appropriate tax consequences for capital gains or losses will apply.

Footnotes:

[1] This statement is taking into consideration an example that the yield generated from a Municipal Bond is after tax money, whereas a yield from qualified accounts is tax deferred, and the income taxes due at the time of withdrawal/distribution from a qualified account would take away a large part of the income generated in the investment made in the qualified account.  This statement is general in nature, and does not account for price fluctuation, risk, solvency, individualized tax needs, and all other risk factors, but rather is made to note this into account when making investment decisions, and should be used for informational and educational purposes.  Please refer to your Financial Advisor, CPA, and other advisors and specialists for more information about your own personal needs before making any decisions.

[2] According to MSRB market statistics, the value of the Municipal Bond market reached $2.9 Trillion as of the end of first quarter of 2011.  For more information please go to www.MSRB.org

[3] To view the complete Municipal Bond Fairness Act and the report on Table A please go to http://www.bondview.com/articles/municipal_bond_fairness_act_us_congress

[4]“SIPC shall be a membership corporation the members of which shall be all persons registered as brokers or dealers under section 78o(b) of this title, other than:
(i) persons whose principal business, in the determination of SIPC, taking into account business
of affiliated entities, is conducted outside the United States and its territories and possessions;
(ii) persons whose business as a broker or dealer consists exclusively of (I) the distribution of
shares of registered open end investment companies or unit investment trusts, (II) the sale of variable
annuities, (III) the business of insurance, or (IV) the business of rendering investment advisory services
to one or more registered investment companies or insurance company separate accounts; and
(iii) persons who are registered as a broker or dealer pursuant to section 78o(b)(11)(A) of this title.

[5] There have been over 360 Bank Failures requiring FDIC assistance in the period between January 2008 and March 2011 according to FDIC.  For more information please go to www.fdic.gov

[6] Over the last 10 years period, the annual average of new cases was four.  Since the SIPC’s inception in 1970, there have been 322 proceedings commenced under SIPA, with customer distributions of approximately $109.3 Billion.  Source: SIPC 2010 Annual Report.  To view entire report please go to http://sipc.org/pdf/2010%20Annual%20Report.pdf or find more information on www.sipc.org

[7] See RISK FACTORS disclosure at the end of the article

[8] Correlation: In the world of finance, a statistical measure of how two securities move in relation to each other.  For a full definition and examples go to http://www.investopedia.com/terms/c/correlation.asp

[http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/

[12] Treasuries have gone down in price significantly since the article was written.  For current prices call your financial advisor or go to link noted in footnote 12.

[13] See footnote 2

[14] As of the date of the revision, there have been 64 Municipal bond defaults totaling approximately $5.4 Billion out of the $2.9 Trillion market, representing approximately 0.2% of market.  Past performance is not a guarantee of future results.