Investing in “Muni” Bonds
Well, here we are folks, about half way through another beautiful summer in Cody Country. Hopefully, you are sitting on the deck with a cool drink and cool breeze as you enjoy the August issue of Cody Living Magazine.
For this issue, I wanted to step outside the box a little bit to cover a specific area of the market that some investors may not be aware of. This is intended to serve as an introduction or brief overview of municipal bonds. As with many aspects of the investment world, the bond market and municipal bonds in particular can get quite complicated.
Municipal bonds, commonly referred to as “Muni” bonds, or “Tax Free” bonds are bonds (debt obligations) issued by local governments, or by one of their affiliated agencies. They are most often used to finance infrastructure related repairs and or public construction such as airports, seaports, roads and schools.
The United States holds the largest market of tradable municipal bonds in the world. Common issuers of municipal bonds include states, cities, counties, public utility districts, school districts, redevelopment agencies and publicly owned airports.
When you purchase a municipal bond, you are lending money to the underlying government entity which, in turn, promises to pay you a stated amount of interest and then return your principal to you on the specific date of the bonds maturity.
Basic Types of Municipal Bonds
Revenue bonds: Interest and principal are paid by proceeds generated from the underlying issuer, such as; rent, tolls or other charges by highways, airports, bridges, hospitals and other facilities
General obligation bonds: Interest and principal are back by the full faith and credit of the underlying issuer rather than by revenues produced. In most cases this is supported by taxing power.
Municipal bonds offer a number of potential benefits, some of which are:
• Federally tax free, and in some cases, state and local tax free income
• The higher your tax bracket, the greater your potential tax benefit from the purchase of Municipal Bonds that are federally and locally tax free.
• A regular and predictable stream of income
• Potential liquidity / marketability prior to maturity
• Investment grade bonds offer a higher degree of safety than investing in equities (stocks)
Some potential risks
Municipal bonds are assigned credit ratings similar to taxable corporate bonds. The three major credit rating agencies are Moody’s, Standard and Poors and Fitch. All three agencies use a rating system that assigns a rating from AAA to D. The highest rating a bond receives is AAA. Generally speaking, bonds rated at least BBB (Standard & Poor’s and Fitch) or Baa (Moody’s) are considered to be “Investment Grade” or suitable for a more conservative investor seeking preservation of capital. Bonds rated below BBB are often referred to as “high yield” or “junk” bonds. There is a correlation between yield and risk. The higher the yield, the higher the risk.
Interest Rate Risk
Bond prices and interest rates have an inverse (opposite) relationship. As interest rates rise, the value of previously issued fixed interest rate bonds decline. This is because new issues of bonds are coming onto the market with higher interest rates, making the older ones less attractive, hence their price declines. This scenario is reversed in a declining interest rate environment.
There are strategies that can be used to mitigate or reduce interest rate risk. One such strategy is called “laddering”, or building a portfolio of bonds with staggered maturities, thereby creating a regular consistent liquidity stream that can be used to repurchase newer issue bonds that are paying higher interest rates.
There are many different special features and provisions associated with municipal bonds, such as zero coupon bonds, insured bonds, put bonds, variable rate bonds and bonds with call provisions. These special features and or provisions can either add to risk or reduce risk.
Individual municipal bonds are generally issued in denominations of $5,000 and are bought and sold in multiples of $5,000 as well.
Municipal bonds can also be purchased via exchange traded funds otherwise known as ETF’s. They can also be purchased in the form of actively managed open ended mutual funds. While purchasing municipal bonds in the form of a fund can provide instant diversification, the investor does not own, individually, each of the bonds in the portfolio, but rather owns “shares” of the fund. This means that the investor does not have the option of receiving his / her principal back at maturity, since there is no maturity date associated with the fund shares. The investor is subject to the share price upon liquidation, which may be more or less than the original purchase price.
For additional information on municipal bonds, please don’t hesitate to call or stop by our Cody office at 1306 Sheridan Ave.
The author, Stephen P. O’Donnell Sr., is President of O’Donnell Wealth Management, a financial planning and asset management firm located at 1306 Sheridan Avenue in beautiful Cody, Wyoming. Steve has 18 years of experience, having worked as a portfolio manager for some of the largest firms on Wall Street. For a no cost, no obligation, initial consultation, call 307-586-4279, email, or simply stop by the office Monday through Friday.
Investment Advisory Services Offered Through Saxony Capital Management, LLC. Securities Offered Through Saxony Securities, Inc. Member FINRA/SIPC.