This is an introduction on how to buy municipal bonds in the secondary market in the most basic sense. Individual investors can buy bonds when the bonds are originally issued or buy bonds in the secondary market after the bonds have already been issued. For the purposes of this article, we will cover buying bonds in the secondary market. We will cover buying bonds as and when they are originally issued through retail order periods in another article. The basic benefit to buying municipal bonds is that the interest income is tax-free of federal income taxes and state income taxes (if you live in the state where the bonds are issued.) Here are the basics:

An Over-the-Counter Market: Investors can buy municipal bonds through bond dealers, banks, and almost all brokerages, online and full-service. The minimum size of a municipal bond purchase is generally $5,000 of par value. Municipal bonds are sold and traded by dealers in an over-the-counter market; there is no centralized exchange where municipal bond transactions take place. Investors buy municipal bonds from licensed securities dealers that actually own the bonds they sell. There over 2,000 registered dealers that are licensed to sell municipal bonds (click to see the list.) All bond trades are reported to the Municipal Securities Rulemaking Board. MunicipalBonds.com lists every single trade reported to the MSRB on a real-time basis throughout the trading day.

In most cases, when you buy bonds, you will be buying bonds that the selling firm owns. This is important to understand because unlike stocks, most bonds available for purchase are actually owned by the dealer or brokerage that is selling them to you. If the bonds you want are not owned by the dealer, the dealer will buy the bonds from another dealer so that they can sell them to you. Either way, a dealer will own the bonds that they sell you. Think of this as a car dealership vs. a Realtor: A car dealership actually owns the cars it sells vs. a Realtor who is an agent in the transaction between the buyer and the seller. As such, just like when you buy a car, there are no commissions. With munis, the profit that the dealer makes is built into the price of the bonds. The profit is known as the “markup” (In some cases, firms will charge you commissions if they are acting on your behalf.) Many brokers and dealers solely specialize in municipal bonds; they will not have any interest in trying to upsell you or steer you into other types of investments.

Here are a few dealers that post their inventory on their sites (click and it will take you directly to the inventory in a new browser window):

FMSBonds.com Stoever Glass Fidelity George K. Baum Lebenthal

Stone & Youngberg Bergen Capital Herbert J. Sims

All major firms such as Merrill Lynch, Smith Barney, Morgan Stanley, Edward Jones, E*Trade, Schwab, RBC, Raymond James, and many other firms also have brokers that specialize in municipal bonds. However, most of these firms do not list their inventory on their websites unless you register or have an account.

Please read The 5 Elements if you’re unfamiliar with how bonds are priced.

Markups vs. Commissions. The broker or the dealer’s profit is built into the price that you will be paying for your bonds. In limited cases, if there is a commission, it will be disclosed to you. The dealer’s profit or markup will not be. (Using the MunicipalBonds.com trade pages, you can get an accurate idea of exactly how much other people paid for any set of bonds and what the markups were in the market.)

Minimum of $5k Investment: The minimum amount of a trade is $5,000 of face value. “Face value” means the amount that you will get back at maturity. You have to buy municipal bonds in increments of $5,000 of face value. Based on the bond’s price, which is priced in terms of ‘cents on the dollar’, you might end up paying more than $5,000 or less than $5,000 for bonds that will pay $5,000 at maturity. If a bond is priced at par or 100, this means you will pay $5,000 for $5,000 worth of bonds.

Maturity Date: This is the date when the bonds will mature and you will get paid back the face value of the bonds you own. Decide if you want your money returned in 6 months, 2 years, 5 years, 10 years, 20 years? Municipal bonds are generally a buy-and-hold investment. If you do not hold your bond to maturity, you will be able to sell them quite easily, but with so many issues and no centralized exchange, the market is not as immediately liquid as it is for other securities. Generally, you should buy municipal bonds with the intention of holding them to the maturity. You should think of buying municipal bonds the same way you think about buying CDs; it does not make sense to terminate early unless you think the risk that you won’t get paid back has increased, will increase, or if you need the money early. If you decide to sell a bond that you own before its maturity date, you will sell the bond in the secondary market. Dealers will buy the bonds from you at a price where they can resell the bonds at a profit to another investor.

Call Dates and Yield to Call: Most bonds can be called or paid back early by the issuer before the maturity date (this is similar to paying off a mortgage earlier than the term.) Many bond issues will have call dates that occur on specific dates in the future. This is important for you to know because a bond maturing in 2030 might have a call date in 2015. If the bond is called in 2015, you will have to find a new investment for the money that has been returned to you. When dealers list bonds that have call dates, they will list something call YTC (yield to call) or YTW (yield to worst); this tells you what your yield will be in the event that the bond is called or paid back early on the call dates.

Safety in Municipal Bonds: With municipal bonds, the value you receive is not only the tax-free interest, but the absence of principal risk to a large degree provided you hold the bonds to maturity. Municipal bond defaults are very rare events; this does not mean that they cannot or do not default. It just means historically municipal bonds have been safe with less than 1% default rate. (Here is a good study on municipal bond defaults by Moody’s.) In addition to the default rates being low, when municipal bonds do default, the recovery rates or amount of money that is able to be recovered is quite high (many times the recovery rate is 100% such as with the Orange County default in the 90’s.)

Generally speaking, you do not need to keep constant tabs on how much your bonds are worth. Bonds will fluctuate in value based on current interest rates and a variety of other factors, but as long you hold them to maturity, you will almost always get all of your money back provided that they do not default. The only time you should start worrying about any specific bond you own is if you think there is going to be an increase in the risk that the municipality will have a tough time paying you back. Regarding bonds in general, prices are largely influenced by 5 factors: Credit risk, interest rate risk, inflation risk, currency risk, and liquidity risk.

Focus on the Yield: The interest rate or coupon determines the amount of interest income that gets paid to you on an ongoing basis. Every 6 months, you will get this amount paid to you. If you buy $10,000 worth of bonds paying 5% interest, this means you will be getting $250 every 6 months. However, yield is the overall return that you will earn from your bond investment. This is based on the price or cents on the dollar that you pay for the bonds. (Read the 5 Elements of a Bond Trade if you need to familiarize yourself with this concept.)

The coupon or interest rate on a fixed-rate municipal bond is fixed. However, you might end up earning a higher or lower yield based on what you pay for the bonds. For example, if you pay 105 or $10,500 for $10,000 worth of bonds with a 5% coupon, your actual return will be less 5%. You will receive $500 per year in interest as per the 5% coupon, but at maturity you will receive $10,000 even though you paid $10,500. As a result, your overall return was less than 5%; this overall return is the yield.

Make sure you understand the relationship between price, coupon, and yield. The relationship between the price of the bond, the maturity date, and the coupon of the bond determines your yield.

Accrued Interest: When you buy a bond, in addition to the price, you will also have to pay the dealer the accrued interest on the bond. This is the amount of interest that has accumulated since the previous date that the bond made its interest payment. For instance, let’s say a 5% coupon bond makes its interest payments on Jan 2 and July 2 and you are buying $10,000 of these 5% coupon bonds on April 2. Since 3 months have transpired since the last interest payment, the bonds that you are buying will have accrued approximately $125 worth of interest even though it has not been paid yet. You basically have to compensate the seller for the interest accrued in the bonds between the time you are buying the bonds and the last time an interest payment was made. On the coupon date, you will receive a full six-months worth of interest regardless of whether you bought the bonds a week earlier or 5 months earlier.

Ratings: Bonds are rated by ratings agencies, Moody’s, Standard & Poor’s, and Fitch Ratings Service. AAA rating is the highest rating possible. Many bonds are also unrated. The issuers pay the ratings agencies to have their bonds rated. The ratings agencies evaluate the quality of the issuer and their ability to pay back their debts. The higher the rating, the less yield you will generally earn. The general relationship is that the higher the credit risk, the higher yield you will earn. The lower the risk, the lower your yield.

General Obligation bonds vs. Revenue bonds: We will cover this in greater detail in the near future, but here is the basic overview: General obligation bonds are serviced or backed by the general taxation powers of the municipal government that issues the bonds. This means that for general obligation bonds to be paid back or serviced with interest payments, the municipality can call upon any form of taxation it needs to make sure it makes good on its obligations. The other kind of municipal bonds, revenue bonds, are tied to one particular form of revenue. For example, a water bond might rely on revenues from people paying their water bills. A highway bond might rely on tolls, a stadium bond might rely on a special tax such as a restaurant and bar sales tax. A revenue bond’s credit quality is dependent on the revenues derived from the purpose of the bond.

CUSIP: All bonds have something called a CUSIP number. This is 9-digit strong of characters that is unique to every new bond issue. This allows you to search on sites like MunicipalBonds.com for the price history of the bonds.

With all bonds listed on the various dealer sites, make sure you check the price history on MunicipalBonds.com to make sure that you are getting quoted a good price. You will be able to see what other investors and other dealers have paid for the bond that you are interested in. Municipal bonds can provide safety of principal, tax-free income, a hedge against future increases in tax rates, and non-existent management fees.

Just as with any investment, municipal bonds are not for everyone. Try to learn as much as you can before investing in municipal bonds.