Although all the talks at dinner parties is around the hot stocks, the role of bonds in a diversified portfolio cannot be overstated.
The advantage of bonds is that they zig when stocks zag.
When everyone gets nervous and shook out of stocks they run to the safety of bonds.
Also because bonds pay interest we have the ability to reinvest quick and actively manage duration and risk exposure. But that’s advanced let’s start with some background.
Even within the bond world, most people want to discuss corporate bonds, but when you are trying to diversify your portfolio one should pay careful attention to the options available outside the corporate world.
Municipalities like townships, counties, states, Regions issue attractive debt instruments. Specifically, there’s a large market for investing in municipal bonds, or “muni” bonds.
What makes these offerings attractive is not only their interest rate terms, but their tax advantage, and low correlation to the stock market.
Specific to the question of whether they are good for a retirement account, the direct answer is “No, not really.” The high return to risk is best recognized in a taxable account because of tax advantages received. Let’s continue to explore.
Let’s talk about the different types of municipal bonds (revenue vs. general obligation), the tax benefits, and how to choose the right bonds for your portfolio.
The Story Behind Municipal Bonds
New York City was the first community to issue a bond in the year 1812 and the proceeds were used to pay to dig a canal.
Since this first issuance the municipal market has increased to 4 trillion.
Most of the notable infrastructure build throughout the United States was funded via municipal bonds.
St. Louis Arch, Seattle Space Needle, Golden State Bridge, etc.
How municipal bonds work
When you buy a bond, you’re agreeing to invest a lump some of money, known as principal, over a fixed duration of time.
The city, county, state that issues the instrument agrees to pay back both the principal when it comes due (Maturity Date), and to make interest payments to you over that holding period.
As an example, you buy a 7-year, $10,000 bond paying 8% interest.
The issuing municipality, in return, will promise to pay you interest on that principal every six months at 8% and then return your original $10,000 once that 7-year period has elapsed.
The difference with Municipal bonds is that they are always exempt from federal taxes.
This advantage also applies when you buy bonds issued by the state you live in, your interest payments are exempt from state and local taxes as well.
It definitely pays (literally) to invest locally.
Types of municipal bonds
Municipal bonds come in two varieties: general obligation bonds and revenue bonds.
General obligation bonds fund projects not linked directly to a defined revenue stream.
Revenue bonds, of course, have a direct tie to the revenue stream they are help creating, augmenting.
General obligation bonds (GOB)
When a city issues a GOB it is backed with the “full faith and credit of the issuer.”
This specifically means that independent of how the funds were used the city remains obligated to make the investors whole.
Because of this broader obligation the default risk on these instruments has been materially lower than Revenue bonds.
With that being said, it is still important to review the credit worthiness of each city before you make an investment.
Revenue bonds (RB)
Revenue bonds are different.
They issued to finance specific projects that have the potential to make money.
Whereas general obligation bonds are backed by the full faith and credit of the issuer, revenue bonds are backed by the income streams they’re tied to.
An investor should start their due diligence not on the credit worthiness of the city but rather the merits of the individual project.
Revenue bonds have a higher default rate than GBOs, but also have a higher return, in general, to help off-set the risk.
How to invest in municipal bonds
Municipal bonds are a little more difficult to invest in than a stock or corporate bond.
There is not a market exchange set to provide a ready exchange between cities and the public.
These deals are conducted directly between two private parties.
If you want to purchase individual municipal bonds, you’ll need to find an individual who can locate the bonds, or you find them directly online, and find someone interested in selling their holding.
However, be careful if you are going through a broker. Because these funds have a different regulatory structure there’s the opportunity for transactional fees to get very high.
The oversight organization is the Municipal Securities Rulemaking Board (MSRB), which governs the muni bond market.
They do establish disclosure rules so you can orient yourself to those details before investing.
You can purchase municipal bonds through different instruments. One way is to buy shares of a Muni-bond mutual fund.
If you go this route you will get instant diversification across many communities, many projects, and different durations. If one city or one project goes bad, you’ll have many others to help cover the loss.
Exchange-traded funds (ETF) are also available in this space and serve the same purpose and have lower fees.
ETFs are typically a much efficient vehicle and can be more tax efficient. I-shares has an ETF with a ticker symbol MUB that is my default choice.
If you are going to build a large portfolio of Muni-bonds I would at Schwab’s market place and consider opening an account with them. Here’s an overview of their offering.
Benefits of municipal bonds
The principle benefit is tax avoidance. These offerings are always exempt at the federal level, and can also be exempt at the state and city level.
Another benefit of buying municipal bonds is that the risk of default is minimal, making them a relatively secure investment.
Between 1970 and 2019, there were only 104 defaults on record among the many thousands of munis issued — and only 9 general obligation bond defaults.
If you go with the highest rated cities, the default risk is further reduced. From a statistical perspective a Muni-bond is 100 times less likely to default than corporate issuances with equivalent risk ratings.
The final benefit is more tactical. If you live in the community that you are investing in, you can watch dollars improve your community. That can be a tremendous feeling.
How to Pick the Right municipal bonds
Because the primary benefit of Muni-bonds is the tax avoidance on interest earned, you’ll want to first investigate the tax savings available to you based on where you live.
Next, you need to do your due diligence and check the creditworthiness of the community or project issuing the bond.
There are three sources that rank issuers based on their likelihood of meeting their financial obligations versus defaulting on them (Standard & Poor’s (S&P), Moody’s, and Fitch).
Conclusion on benefits of municipal bonds
Municipal bonds let you invest in projects that build and better communities.
They also offer an opportunity to secure a steady stream of interest income without exposing yourself to undue risk.
That said, they aren’t for everyone, so it pays to weigh their advantages against their drawbacks to see if they belong in your portfolio.
If you do decide to invest in munis, be sure to research your bonds thoroughly, in terms of both your issuer’s credit rating and the price you’re being quoted for your bonds.
The more educated a decision you make, the more likely your investments are to pay off the way you want them to.
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