FAQs: Frequently Asked Questions on Municipal Bonds


August 12, 2011

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What are municipal bonds?

Municipal bonds are bonds issued by states, local governments, school districts, power districts, and many other forms of government to raise money for projects dedicated to the public interest. Schools, bridges, hospitals, power plants, and many forms of public infrastructure are built from the money raised by issuing municipal bonds.

Why do people buy municipal bonds?

Tax-exempt interest. The primary reason people buy municipal bonds is that the interest received from municipal bonds is tax-exempt with regard to U.S. federal income taxes. Additionally, if the bonds are issued in your state of residence, the interest may be tax-exempt from your state s income taxes. For instance, a California resident would not pay California state income tax or federal income tax on the interest received from California State General Obligation bonds.

Who benefits the most from municipal bonds?

As a general rule, the higher your tax bracket, the greater the benefit from tax-exempt interest. For instance, a bond yielding 5% tax-free is more beneficial to a person in the 35% federal tax bracket as opposed to someone in the 15% tax bracket. The person in the highest tax bracket receives a significant benefit from the tax-exempt interest. For a person in the 35% tax bracket, to equal 5% tax-free interest, he or she would need to earn 7.7% taxable interest from CDs or corporate bonds.

Who owns municipal bonds?

As of 2010, there are about $2.8 trillion in municipal bonds outstanding. Of this amount, $1 trillion are directly owned by US households. Another $1 trillion is held by bond funds, money market funds, and closed-end funds. The rest are held by banks, insurance companies, and the like. Foreigners, corporations, and central banks do not buy municipal bonds in a big way because these types of investors do not benefit from U.S. tax-exempt interest.

Are municipal bonds safe?

Historically, municipal bonds have had a strong record of safety compared to corporate bonds. Certain types of municipal bonds have been historically much safer than others. No state has defaulted on State general obligation municipal bonds since the Civil War. The key difference in risk can be found between general obligation bonds and revenue bonds. Safety is a component of the risk of the project being financed, the economic characteristics of the area, the tax backing of the bonds, and many other factors. Investors need to understand the default characteristics of municipal bonds.

In addition, investors should understand the recovery rates when municipal bonds do default. Recovery rates are the percentage of the money owed that the bondholder ultimately recovers after the bonds default. This is important to know because all is rarely lost when a municipal bond defaults. For instance, with the Orange County default in 1994, the bondholders were paid back 100 cents on the dollar with interest within 18 months of the default.

What are general obligation bonds or G.O.s?

With general obligation bonds, the issuer of the bonds is using its taxation power to back the interest payments and ultimate repayment of the bonds. For instance, when a state, city, county, township, school district issues general obligation bonds, the entire taxation power of the issuing government is backing the bonds. This mean that if the municipality runs into any financial difficulty, it will need to raise taxes in any form that it can to the point that bondholders can be paid back. Many states, including California, have it written into their constitutions that bondholders of state-backed debt must be paid before any money can be used for any other obligation. In California, bondholders of the state are the second in line after the needs of K-12 education. Local municipalities back their general obligation bonds with property taxes as this is usually the sole method of taxation available to most small towns. If a local government has a financial problem, it must raise its property taxes to the point that it can service the municipal bonds that it has issued. If it does not, a judge can issue something called a writ of mandamus that can force the municipality to raise taxes and pay bondholders. School districts issue general obligation bonds backed by one or multiple towns that constitute a school district. In a nutshell, a general obligation bond means that the issuer is obligated to pay the interest and principal on the bonds from any source of revenue it can get its hands on. This gives GOs a certain degree of safety compared to revenue bonds.

What are revenue bonds?

Revenue bonds are backed by the revenues expected to be generated from the project being financed. Hospitals, housing projects, buildings to be leased to governments, sewer systems, power generation, all generate revenue after the initial project is financed and built. With revenue bonds, the revenues generated from the project is the money used to pay the interest and principal on the bonds.

For instance, if a bridge authority issues revenue bonds to build a toll bridge, the tolls collected when drivers drive over the bridge is the money that will be used to pay the interest and ultimately the principal back on the bonds. Unlike general obligation bonds, the power of the bridge authority is limited in the practical sense: If the expected toll bridge traffic is not there, tolls will need to be increased to compensate for the revenue shortfall. Unfortunately, if tolls are increased by too big a factor, the revenues would decline even more as people take alternate routes to avoid the tolls. Other types of revenue bonds such as bonds issued by water systems, sewer systems, power generation and distribution systems are considered to be more essential in nature. Not only can the utilities that issue the bonds increase the prices of these sewer, water, and power, but the ability for an homeowner to choose an alternative to the public utility is limited. As such, the safety of revenue bonds issued by issuers providing essential services are considered to be superior in credit quality to non-essential services.

What is the difference between coupon and yield?

Coupon is the fixed rate of interest that the issuer pays on an annual basis. For instance, a 5% coupon on a bond with $100,000 of face value will pay $5,000 of annual interest to the bondholder. If interest rates go down considerably, the attractiveness of a 5% bond will increase, the seller of the bond will want a premium for the bond this will result in a lower yield or total overall return to the buyer of the bond. For bond investors, the amount of interest received annually is set by the coupon, but the overall yield or total return is determined by the yield. Understand the 5 elements of municipal bonds>>>

What is price?

The easiest way to understand price is that bonds are priced on a cents on the dollar basis. When a bond is priced at 100, this means that the investor is paying 100 cents on the dollar for the value of the bonds. If the investor buys $5,000 worth of municipal bonds, the investor will pay $5,000 to the seller when the bonds are priced at 100. If the bonds were priced at 90 (90 cents on the dollar), the investor would be paying $4,500 for $5,000 worth of bonds. On a fixed rate municipal bond, the coupon or interest rate is fixed. In this scenario, a 5% coupon would pay the bondholder 5% of $5,000 on an annual basis even though the investor only paid $4,500 for the bonds. Any new bond investor considering bonds should make themselves thoroughly aware of these basic concepts.

What is the minimum amount of municipal bonds that I can buy?

Generally, the minimum amount you can purchase is $5,000. Municipal bonds are traded in increments of $5,000. For example, $5,000, $10,000, $25,000 .

What are ratings?

Ratings are a judgment of credit quality made by the 3 big ratings agencies: Moody s, Standard & Poor s, and Fitch Ratings. Municipal bond issuers such as states and local municipalities pay the ratings agencies to have their credit quality rated. A top credit rating of AAA or Aaa means that municipality can borrow at a lower rate of interest than with a lesser rating. This is similar to individual credit ratings, the higher an individual s credit rating, the lower the interest rate. The same logic applies to municipal borrowers. Learn more about credit ratings>>>

How are municipal bonds bought and sold?

Municipal bonds are not traded on an exchange or through a centralized market. Bonds are traded in an over-the-counter market between dealers. Investors can buy bonds through full-service brokerages such as Merrill Lynch, Morgan Stanley, Edward Jones; Discount and online brokerages such as Zions Direct, Munigo, and others also sell bonds. For individual investors, there are also bond dealers and bond brokerages specialize in selling and trading municipal bonds.

How do dealers and bond salesman make money?

Unlike stocks, bonds are generally sold with a markup. This is the difference between the price the dealer pays for the bonds and the price the dealer sells the bonds to you. In an over-the-counter market, dealers actually own the bonds and incur the market risk of owning the bonds in their inventory. With stocks, brokerages simply execute a buy or sell order that gets executed and matched up with a buyer or seller. With bonds, the dealer has to either own the bonds in their own inventory or has to buy the bonds from another dealer before selling them to you. The markup between the dealer s cost and price you pay is the dealer s profit. If you pay a commission on a bond transaction at most online brokerages, there might also be a markup in addition to the commissions being charged. Read the fine print.

Why are transaction costs with bonds higher than for stocks?

There are many reasons. 1) Bonds are sold in an over-the-counter market where dealers incur market risk. 2) A stock commission of $8 is not the true cost of a stock trade. On many stock trades, the brokerage gets paid order-flow payments from market makers. Market makers are the people making the stock market more efficient by always having a price that they are willing to sell a particular stock for and a price that they are willing to buy a particular stock for. The market makers then make a spread or profit on stock trades. After all, market makers would not be paying brokerages for order flow unless they were able to make a profit from the order flow. This is the true cost of stock trades. In the bond market, the full profit between the dealer s cost and investor s price is more apparent. A dealer might make between .25% and 2% of a bond trade on most trades.

Are dealer markups too high?

Perhaps, perhaps not. The primary consideration for the investor should be the yield. The yield quoted to you is inclusive of all of the transaction costs and dealer markup; if the yield is attractive to you given the risk profile of the bonds, the markup should not matter unless you can buy the exact same bonds at a better price from a different dealer, which you might be able to do and should do if you can. An additional consideration regarding markups is the duration of the bonds that you are buying. If you are buying a bond maturing 20 years from now, think of the initial dealer markup as your entire transaction cost over 20 years. To accurately understand this, compare the markup to the 1% annual asset management fee charged by many full-service investment managers. Instead of being charged .5%-1% every single year on managed money, a bond trade with even a 2% markup is a one-time charge for a 20-year investment with no additional charges for the entire 20 years. An investor should also compare this to the fees with mutual funds. The financial advisor selling you a mutual fund can receive up to 5% upfront for getting you to purchase a mutual fund without you knowing. Additionally, the advisor selling you a mutual fund may receive annual fees from the fund. When buying a bond, the ultimate consideration should be your expected yield on the investment. The lower the price you pay for the bonds, the better your yield will be. But do not be penny-wise, pound foolish. Dealer markups, when truly compared to the costs of other investment products, are not necessarily unwarranted or egregious.

Wouldn t it be easier to buy a bond fund rather than individual bonds?

One of the biggest benefits to a bond fund is diversification. However, unlike with stocks, a bond fund can neutralize one of the biggest benefits of owning bonds: A guaranteed rate of interest and the guaranteed return of principal (provided the bonds do not default). When an investor buys a bond, he is guaranteed a rate of return and a maturity date on which the investor will get paid back exactly the amount of money that he was expecting. Owning a bond fund is the equivalent of owning a share in a portfolio of bonds that changes over time. The investor is not guaranteed a fixed rate of interest and the return of principal, but the current value and income of the bond portfolio at a given point. The investor does get instant liquidity unlike with a bond, which an investor has to sell to a dealer. For investors that want to control the exact timing of their cash flow from interest and be assured of exact dates for return of principal, buying a portfolio of individual bonds is a superior strategy to buying a bond fund.

What are the risks of bond investing?

With bonds, a person has to evaluate credit risk, whether the entity is going to pay them back on time and in full. Other risks are inflation risk, interest rate risk, liquidity or marketability risk, call risk, legislative risk, and reinvestment risk. Learn more about the risks of investing in bonds. A bond investor s goal is to get exactly what they expect, which are the scheduled payments of interest and the return of principal on the maturity date.

Are bonds harder to value and evaluate than stocks?

With stocks, people have to value a company s earnings, products, balance sheet debt, margins, capital expenditures, competitive position, management, currency risk, regulatory issues among many other factors, and the general perception of the company by other investors. People generally don t think valuing stocks are that complicated, even though the factors are very complicated. With bonds, the basic factors to evaluate are the quality of the issuer and the base of revenues or security backing the bonds. After that, it is determining whether the maturity length and yield available are acceptable given your evaluation of risk. Every part of a bond investor s evaluation should involved the likelihood of being paid back in addition to things like inflation, marketability, interest rates, legislative issues.

For instance, if you expect tremendous inflation, the maturities that you should be buying should be short-term. If tax rates go down materially, the benefit from municipal bond interest would be lower and bond yields would be higher. If the tax-exemption on bond interest is eliminated, municipal bond yields would have to be higher and comparable to taxable bonds. If you ever need to sell bonds prior to maturity, a bond that is widely held will be more marketable or easier to sell than one that isn t. For instance, a California St General Obligation bond is a more well-known name than a small town in Iowa. Being aware of these factors is an important part of being a knowledgeable bond investor.

 

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