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The Coming Collapse of the Municipal Bond Market - by Frederick J. Sheehan

Welling@Weeden, published by financial journalist Kathryn M. Welling, is a biweekly journal of investment research and opinion for sophisticated investors distributed exclusively to clients through institional brokerage, Weeden & Co. LP. For further information, please see http://welling.weedenco.com. Frederick J. Sheehan, who wrote the article for Welling@Weeden, is the author of the just-published ‘Pander to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession’ (McGraw-Hill Cos.)

Long-Term Issue Credit Ratings

Issue credit ratings are based, in varying degrees, on the following considerations:

· Likelihood of payment—capacity and willingness of the obligor to meet its financial commitment on an obligation in accordance with the terms of the obligation;
· Nature of and provisions of the obligation;
· Protection afforded by, and relative position of, the obligation in the event of bankruptcy, reorganization, or other arrangement under the laws of bankruptcy and other laws affecting creditors’ rights.

Issue ratings are an assessment of default risk, but may incorporate an assessment of relative seniority or ultimate recovery in the event of default. Junior obligations are typically rated lower than senior obligations, to reflect the lower priority in bankruptcy, as noted above. (Such differentiation may apply when an entity has both senior and subordinated obligations, secured and unsecured obligations, or operating company and holding company obligations.)

AAA
An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.

AA
An obligation rated ‘AA’ differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.

A
An obligation rated ‘A’ is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories. However, the obligor’s capacity to meet its financial commitment on the obligation is still strong.

BBB
An obligation rated ‘BBB’ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

BB
An obligation rated ‘BB’ is less vulnerable to nonpayment than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation.

B
An obligation rated ‘B’ is more vulnerable to nonpayment than obligations rated ‘BB’, but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on the obligation.

CCC
An obligation rated ‘CCC’ is currently vulnerable to nonpayment, and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation.

CC
An obligation rated ‘CC’ is currently highly vulnerable to nonpayment.

C
A ‘C’ rating is assigned to obligations that are currently highly vulnerable to nonpayment, obligations that have payment arrearages allowed by the terms of the documents, or obligations of an issuer that is the subject of a bankruptcy petition or similar action which have not experienced a payment default. Among others, the ‘C’ rating may be assigned to subordinated debt, preferred stock or other obligations on which cash payments have been suspended in accordance with the instrument’s terms or when preferred stock is the subject of a distressed exchange offer, whereby some or all of the issue is either repurchased for an amount of cash or replaced by other instruments having a total value that is less than par.

(Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, and ‘C’ are regarded as having significant speculative characteristics. ‘BB’ indicates the least degree of speculation and ‘C’ the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.)

D
An obligation rated ‘D’ is in payment default. The ‘D’ rating category is used when payments on an obligation are not made on the date due even if the applicable grace period has not expired, unless Standard & Poor’s believes that such payments will be made during such grace period. The ‘D’ rating also will be used upon the filing of a bankruptcy petition or the taking of similar action if payments on an obligation are jeopardized. An obligation’s rating is lowered to ‘D’ upon completion of a distressed exchange offer, whereby some or all of the issue is either repurchased for an amount of cash or replaced by other instruments having a total value that is less than par.

Plus (+) or minus (-)
The ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.

NR
This indicates that no rating has been requested, that there is insufficient information on which to base a rating, or that Standard & Poor’s does not rate a particular obligation as a matter of policy.

Short-Term Issue Credit Ratings

A-1
A short-term obligation rated ‘A-1′ is rated in the highest category by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is strong. Within this category, certain obligations are designated with a plus sign (+). This indicates that the obligor’s capacity to meet its financial commitment on these obligations is extremely strong.

A-2
A short-term obligation rated ‘A-2′ is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher rating categories. However, the obligor’s capacity to meet its financial commitment on the obligation is satisfactory.

A-3
A short-term obligation rated ‘A-3′ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

B
A short-term obligation rated ‘B’ is regarded as having significant speculative characteristics. Ratings of ‘B-1′, ‘B-2′, and ‘B-3′ may be assigned to indicate finer distinctions within the ‘B’ category. The obligor currently has the capacity to meet its financial commitment on the obligation; however, it faces major ongoing uncertainties which could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation.

B-1.
A short-term obligation rated ‘B-1′ is regarded as having significant speculative characteristics, but the obligor has a relatively stronger capacity to meet its financial commitments over the short-term compared to other speculative-grade obligors.

B-2.
A short-term obligation rated ‘B-2′ is regarded as having significant speculative characteristics, and the obligor has an average speculative-grade capacity to meet its financial commitments over the short-term compared to other speculative-grade obligors.

B-3.
A short-term obligation rated ‘B-3′ is regarded as having significant speculative characteristics, and the obligor has a relatively weaker capacity to meet its financial commitments over the short-term compared to other speculative-grade obligors.

C
A short-term obligation rated ‘C’ is currently vulnerable to nonpayment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation.

D
A short-term obligation rated ‘D’ is in payment default. The ‘D’ rating category is used when payments on an obligation are not made on the date due even if the applicable grace period has not expired, unless Standard & Poor’s believes that such payments will be made during such grace period. The ‘D’ rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action if payments on an obligation are jeopardized.

Dual Ratings

Standard & Poor’s assigns “dual” ratings to all debt issues that have a put option or demand feature as part of their structure. The first rating addresses the likelihood of repayment of principal and interest as due, and the second rating addresses only the demand feature. The long-term rating symbols are used for bonds to denote the long-term maturity and the short-term rating symbols for the put option (for example, ‘AAA/A-1+’). With U.S. municipal short-term demand debt, note rating symbols are used with the short-term issue credit rating symbols (for example, ‘SP-1+/A-1+’).

Moody’s Municipal Bond Default Rates 1970-2000

The primary concern of all bond investors is whether they will ultimately get their money back. This is especially the case with municipal bond investors: Municipal bond investors willingly accept lower yields compared to other fixed income investments primarily due to the safety record of municipal bonds.

When an issuer fails to live up to the payment obligations of a particular bond issue, the bond is considered to be in default. However, when an issuer misses an interest payment or fails to pay back the principal on the scheduled date, this does not necessarily mean that the investor will not get some or all of their money back. With municipal bond defaults, investors many times get most of their money back. The amount of money that the investor receives from a bond investment that has defaulted is known as the recovery rate.

The 3 largest ratings agencies, Standard & Poor’s, Moody’s, and Fitch Ratings, have each produced a case study examining default risk and recovery rates of municipal bonds. We will summarize the findings from each of these studies below. Investors may also click on the following links to directly access the three studies.

Fitch Ratings:

Default Risk and Recovery Rates on U.S. Municipal Bonds

Standard & Poor’s:

U.S. Municipal Rating Transitions and Defaults, 1986-2009 

Moody’s

Moody’s Municipal Bond Rating Scale

http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20pages/Credit%20Policy%20Research/documents/current/2001700000407258.pdf

Summary:

Each of the 3 ratings agencies assigns ratings to various municipal bond issues as a part of their business; the ratings classify credit risk just as an individual’s credit score is used to assess credit risk. Generally, a municipal issuer such as a school district or a state pays the rating agency to have an upcoming bond issue rated. Just as with individuals, the better the credit rating, the cheaper it is for the issuer to borrow money. The ratings agency analyzes the various risk factors associated with a particular bond issue and the issuer. Based on the rating agencies assessment of the risk factor, the issuer is assigned a credit rating (Aaa, AAA, Baa, etc…).

In its 2003 study, Fitch Ratings concluded the following:

Based on two studies released in 1999 and 2003, Fitch reviewed all municipal bond defaults between 1987-2002. Based on the results of its findings, Fitch Ratings came to conclusion that the different types of municipal bonds fit into three categories of default risk….Class 1, Class 2, and Class 3.

Class 1, the safest category, is comprised of most local and state general obligation bonds. Class 1 also includes general obligation and revenue bonds issued by established authorities with no competition or natural monopolies in essential public services. Altogether, Class 1 includes the following types of bond issues:

-       State general obligation bonds

-       Local general obligation bonds

-       Local school districts

-       Appropriation-backed and tax-backed debt of local and state governments

-       Public power distribution

-       Water and Sewer Authorities

-       Public higher education

-       Single family housing

In this category of issuers, the cumulative default rate between 1987-2002 was .24%; the comparative default rate during this same period for AAA-rated global corporate debt was .43%.

Class 2 from a default perspective is comprised of public service enterprises providing essential services, but where the enterprise is subject to competition or fluctuation in demand. The bonds issued in Class 2 are generally revenue bonds providing services such as:

-       Public power generation (as opposed to distribution which is in category 1)

-       hospitals

-       waste disposal

-       private colleges and universities

-       military and state multifamily housing

-       museums and stadiums

-       airports and seaports

-       toll roads with established traffic patterns

In Class 2, the five-to-fifteen year cumulative default rate between 1987-2002 was .70%; the comparative default rate during this period for AA-rated corporate bonds was .73%. The types of bonds in Class 2 have a similar default rate to AA-rated corporate bonds according to the Fitch Ratings study.

In Class 3, the issuers are comprised of entities that compete with private enterprises and have highly unpredictable or volatile revenue streams. These types of issuers include:

-       Nursing homes and continuing care retirement facilities

-       Industrial development bonds

-       Local Multifamily housing

-       Toll roads without established traffic patterns

-       Tobacco bonds

-       Tribal gaming

In Class 3, the five-to-fifteen year default rates of 3.65% are comparable to 3.97% for ‘BBB+’ rated corporate bonds.

An interesting assessment made by the Fitch study is that Fitch expects that even if the ratings are similar, a single A-rated airport bond will have a higher expected default rate than a state or school district also rated single A. This should lead an investor to place an emphasis on the type of bond issue being considered in addition to the bond’s rating. Municipal bonds rated similarly can have vastly different characteristics. According to this Fitch study, the type of issuer and issue is as important as the credit rating when evaluating the likelihood of future default.

Recovery Rates:

When a municipal bond defaults, the investor generally will still receive some money back from their investment; this is known as the recovery rate. In some cases and with certain types of issuers, the recovery rate can be as high as 100% or 100 cents on the dollar. In some cases, a temporary default on interest payments can be cured with some late payments from the issuer and the issuer can resume servicing the debt once again according to schedule.

Comparing different categories of municipal bonds to corporate bonds maybe accurate in terms default rates, but the recovery rates are another matter according to Fitch. Corporate bonds have an average recovery rate of about 40% or 40 cents on the dollar.

Fitch in this study creates 6 classes of recovery rates. The first 3 classes are assumed to have recovery rates of 100% of the principal. 

Class 1: 

-       State GO debt

-       State sales tax backed debt

In the event of default in this class, Fitch assumes a recovery rate of 100% of the principal amount with an assumed loss of 1-years interest.

Class 2:

-       Local general obligations

-       Local tax-backed debt

-       Transit authorities

-       Water, sewer, gas

-       Public colleges and universities, GO and tuition-revenue backed

-       Single family housing

For Class 2, Fitch assumes a recovery rate of 100% of the principal with 2-years of missed interest payments.

Class 3:

-       local and state leases, certificates of participation, and appropriation-backed

-       Airports and seaports

-       Power distribution

For Class 3, Fitch’s model assumes a recovery rate of 100% with 5-years of missed interest payments.

Class 4:

-       Waste disposal

-       Nursing homes and retirement facilities

-       Private colleges and universities

-       Established Bridges and roads

-       Museums and stadiums

-       Public power generating facilities

-       State and local multifamily housing

For class 4, Fitch’s model assumes a recovery rate of 90%.

Class 5           

-       military housing

-       start-up and new bridges and toll roads

For Class 5, Fitch’s model assumes a recovery rate of 70%.

Class 6:

-       private prison

-       stadiums

-       student housing

-       private university bonds backed by auxiliary revenues

-       hospitals

-       tribal gaming

For Class 6, Fitch assumes 40% recovery rates.

Fitch doesn’t explicitly address where many other types of bonds such as industrial development bonds, tobacco securitizations, etc..

Conclusion:

The way an investor would use this information is by being aware of the default risk and recovery rates of various categories of municipal bonds. Rather than simply relying on a rating or a recommendation, information such as this historical analysis from Fitch Ratings should provide you an additional set of data points in helping you understand the risks of investing in municipal bonds.

Investors should be aware that this is simply one analysis done by Fitch Ratings in 2003 and the information should be considered as an educated opinion based on a historical analysis of municipal bond defaults.  

Additionally, municipal bonds can be free of state income taxes as well. In most states, for residents of the state where the municipal bond issuer is located, the interest income from municipal bonds is free from state income taxes. For instance, a resident of Los Angeles can buy any municipal bond issued by a municipality in California and does not have to pay California state income taxes on the interest income. However, if the same LA resident purchased a Texas municipal bond, the income would be tax-free on a federal level, but the California resident would owe state income taxes since it is a bond issued out-of-state.

Other tax exemptions can include being free of city income taxes as well in cities like New York City when qualifying municipal bonds are purchased. Most municipal bonds are also free of AMT or the alternative minimum tax.

As a result, the higher the investor’s tax bracket, the benefit of the tax-free income becomes greater. A person in the 35% tax bracket receives more benefit from the tax savings than does a person in the 25% tax bracket. To compare the tax-free interest from municipal bonds to other taxable interest-bearing investments, people often compare the “tax-equivalent yield”.

Tax-equivalent yield is simple to understand as a concept. Let’s say that a bank CD is paying 6% and a municipal bond issued in your state pays 4%. On an investment of $10,000, the bank CD earns $600 in annual interest while the municipal bond earns $400. However, a person in the 35% tax bracket must pay 35% of the $600 in federal income taxes, which is $210 in taxes resulting in $390 after taxes. The municipal bond in this case offers a better tax-equivalent yield earning $400 tax-free annually. Additionally, the interest from the CD will also be taxed at the state-level whereas the municipal bond will be free of state income taxes as well.

For an investors in high-tax states such as California and New York, the benefits of tax-free bonds are even greater than for residents of states without any state income tax such as Washington State or Nevada. The higher your state’s income taxes, the bigger your benefit from municipal bonds.

The other major benefit of owning municipal bonds is that they can serve as a hedge against future tax increases. For instance, if taxes go up on a federal or state level, the interest income from municipal bonds will remain constant since it is tax-free. As such for investors in tax brackets where tax increases are likely, municipal bonds can offer a level of protection.

3 of the 5 elements are similar to the elements of a bank CD. For a CD, these are the amount invested, the length of the CD, and the interest rate. For a municipal bond, the 3 similar concepts are face value, maturity, and interest rate.

Maturity: Like the length of a CD, every municipal bond issue has a maturity date; this is when the issuer, the municipality, has to pay back the money it borrowed when it originally issued the bond. If an investor held the bond until the maturity year, this is the point at which the bonds will be redeemed or paid back. Most municipal bonds are issued with maturity dates longer than 10 years, usually more than 20 years.

Interest Rate: This is also known as the ‘coupon’. Municipal bonds pay interest. On most municipal bonds, the issuer (town, state, school district…) will pay the interest rate specified in the bond. This interest payment is generally paid semi-annually or once every 6-months. For example: A 4% coupon on $100,000 worth of bonds would receive $2,000 every 6-months paid by the issuer.

Amount Traded/Face Value of Bonds: Also known as par value, this is the amount that the investor will be paid back at the maturity date. If an investor purchases $10,000 worth of bonds, this means that the bonds at maturity will be redeemed for $10,000. On MunicipalBonds.com data pages where we report trades, we call this the ‘amount traded’.

Example: This is a series of trades for a bond issued by the Beverly Hills Unified School District.

In the example above, this Beverly Hills School bond issue has a maturity date of August 2026. It pays 5% interest on the amounts traded. Each trade above is a different investor buying or selling this Beverly Hills Unified School District bond issue.

The 2 more complicated components: Yield and Price

Investors should fully understand the concepts of yield and price before investing in bonds. Price and yield are the only elements of a bond that fluctuate based on market conditions.

Price: All bond trades and investments include a component called ‘price’. The best way to understand the concept of ‘price’ is to think of this as ‘cents on the dollar’. All bonds are basically quoted as cents on the dollar; 100 is par or 100 cents on the dollar. A price of 100 would mean that $10,000 worth of bonds would cost you $10,000. A price of 95 means that $10,000 worth of bonds would cost you $9,500. A price of 103 means that $10,000 worth of bonds would cost you $10,300.

In the Beverly Hills trade example below, $20,000 of face value were bought by an investor at a price of 107.246. This means the investor paid 107 cents on the dollar which is the equivalent of $21,449. (1.07 times $20,000=$21,449.) This is what the investor paid the seller.

On his investment of $21,449, he is going to collect 5% interest on the face value of $20,000; this is $1,000 per year. (Interest payments are generally made every 6 months, so he will receive $500 every 6 months.)

If he keeps the bond to maturity to August 2026, the Beverly Hills School District will pay him $20,000 to redeem the bonds. If he keeps his bonds to maturity, he would have earned a yield of 2.815%. Here’s why:

Since he paid $21,449 for bonds that will be redeemed at for $20,000, his annual return is not simply the $1,000 he receives in interest payments every year.

Something has to also account for the fact that he will be receiving $1,449 less at maturity than he paid; factoring in all of this is the concept of ‘yield’. His yield of 2.815% will be this investor’s actual percentage return if he holds to maturity.

Yield: The yield is the overall percentage return that investors will receive. Yield factors in maturity, interest rate, and price to give investors a number that is the actual return on each investment.

The reason that bonds sell for more or less than their face value is due to a variety of reasons. The most common reasons are changes in interest rates and perceived changes in credit risk. In our Beverly Hills case above, the investor feels that a yield of 2.815% is a good deal considering that Beverly Hills School District is a good credit risk. Beverly Hills collects money from property taxes; the assumption is that this will not be at risk over the next 17 years. He might also make a comparison to other investment products such as CDs and US treasuries that are yielding less on a tax-equivalent basis. (Remember, a taxpayer in California does not have to pay State or Federal income tax on the interest earned from municipal bonds.)

Based on other comparable interest-bearing investments, the investor has decided that the safety and tax-free elements make 2.815% yield through 2026 acceptable to him.

Another Example of Yield and Price:

Let’s suppose that an investor bought $10,000 worth of bonds with a 5% coupon with a 20-year maturity at a price of 100; this means he paid $10,000 for $10,000 worth of bonds. After 10 years, he decides he wants to sell the bonds; the investor still has 10 years left before his bonds mature.

Let’s say that current interest rates on similar bonds that mature in 10 years are now paying 7%, but our investor’s bonds are only paying 5% interest. Our investor will have to sell his bonds for less than a price of 100 or less than $10,000 to account for the fact that his bonds are only paying 5% interest. Our investor will have to price his bonds lower than the face value to make it attractive compared to newly-issued bonds that pay 7%.

Yield: Yield is the actual % return that an investor receives from a bond investment. Yield and interest rate are closely related, but can be widely different based on current market conditions. The interest rate on any bond is a fixed component. An issuer agrees to pay a set rate of interest for the life of the bond regardless of the market (think of it as a fixed-rate mortgage). Yield is based on market conditions and the market for bonds.

In our example above, our investor will be selling his $10,000 worth of bonds for less than $10,000. His bonds pay an interest of 5% or $500 per year. Let’s say that a buyer purchases the bonds for a price of 95 or $9,500. The buyer will now be receiving $500 per year in interest on his $9,500 investment. $500 interest on $9,500 is greater than 5%. In addition, at maturity, the bonds will be redeemed for the face value of $10,000 even though the investor paid $9,500. The yield adjusts for the discounted price that the buyer paid for the bonds.

The yield is the overall return that investors receive from bond investments. When bonds are priced at 100 or par value, the interest rate and the yield will be almost identical. If the bonds trade for more than 100, the yield will generally be lower than the interest rate. If the bonds trade for less than 100, the yield will be generally higher than the interest rate.

Please make sure that you understand the concept of yield and price thoroughly before investing in bonds on your own.

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.

Investors can buy new issues of municipal bonds through a process called a Retail Order Period. Municipal bond issuers such as states, school districts, and cities know that individual investors have an interest in buying municipal bonds when they are first issued (the reason is explained below). To make the bonds available to individual investors, municipal bond issuers will provision for a retail order period of 1-2 days before the bonds are officially priced and offered to institutional investors. The minimum investment during a retail order period is usually $5,000 of par value and the maximum investment is usually $1 million.

The Benefit of Retail Order Periods

Retail order periods provide individual investors with as little as $5,000 to benefit from the same yield that major, institutional investors receive. The bonds have no markups or commissions. The bankers simply receive their underwriters discount on the bonds that is negotiated with the issuer (this is the equivalent of their investment banking fee). Every investor, regardless of size or sophistication, receives the same deal. This creates a degree of safety for investors in knowing that a large dollar amount of bonds were sold at the same prices to others as was sold to them. The additional benefit for individual investors is that they get to act first and get an opportunity to buy new issues even before institutional investors.

Many states, cities, and municipalities will be making efforts to make sure that their new issues are offered through retail order periods. Investors should consider buying municipal bonds through retail order periods when they are available and accessible.

How Retail Order Periods Work

For new issues, municipal bond issuers will ask their senior banker (the banking firm that is responsible for managing the deal and bringing it to market) to coordinate a retail order period . Senior bankers are often firms such as Citigroup, Morgan Stanley, Goldman Sachs, Merrill Lynch, but can also be regional or specialty firms responsible for managing the deal. A typical bond issue will have a syndicate of bankers and perhaps a selling group. This just means that the senior banker has a list of partner firms that will help sell the new bond issue to investors, both individuals and institutional investors.

If an investor has an account at any of the firms that are a part of the syndicate or the selling group, the investor can place an order for the bonds once the retail order period commences through their broker at the respective firm. Investors can also tell their brokers to let them know of upcoming bond issues. Investors can also open an account at one of the firms that is a part of the syndicate in order to place an order for the bonds. To run an effective retail order period, the issuer and the senior banker will often run advertising to let investors know about an upcoming issue and the retail order period.

On the actual days of the retail order period, investors will be able to place orders for the bonds based on a preliminary pricing schedule that the broker will provide the investor. For instance, on California’s recent $4 billion General Obligation issue, the preliminary pricing looked like the schedule below. Most bond issues will be structured to mature over a variety of maturity years (the year when the bonds will be redeemed and the investors will be paid the face value of the bond.) In addition, the preliminary pricing includes the amount (par value) of bonds available for each maturity year as well as the expected coupon rate and yield for each maturity year.

Example: Preliminary Pricing for a Retail Order Period

Dated Date: April 1, 2009
First Coupon: October 1, 2009
Due Date: April 1, 2009

An investor that receives the preliminary pricing information has to decide on a few things:

1. Maturity - How long do they want their money tied up?
2. Coupon - What is their desired actual amount of annual interest? This is paid once every six months.
3. Yield - Is the corresponding yield acceptable or attractive to them? Remember, yield is the overall return an investor receives on their investment.

(If you are unfamiliar with the relationship between price, coupon, and yield, please read the 5 elements of a municipal bond trade.)

For instance, an investor that has $100,000 that they want to invest over 3-5 years in maturity would need to choose between the bonds available in 2013, 2014, and 2015. On this preliminary pricing schedule provided above, the proposed yields are as follows:

• 2013 - yield: 3.25 - coupons available: 3.25% and 5%
• 2014 - yield: 3.75 - coupons available: 3.75% and 5%
• 2015 - yield: 4.1 - coupons available: 4% and 5%

As you can see, the investor can also choose between 2 coupons for each maturity year even though the overall return for any given year will be the same. This simply means that the investor can choose to receive a larger interest payment each year or a smaller interest payment each year. The overall yield for each maturity year is still the same, but he will be able to pay a lower price for the bonds if he chooses the lower coupon.

The main consideration is the yield. Let’s say that our investor chooses to place an order for $50,000 of 3.25% coupon bonds maturing in 2013 and $50,000 of 3.75% coupon bonds maturing in 2014. The yield that the investor expects is 3.25 and 3.75. The order that the investor places is binding unless the issuer decides to lower the yield.

This works like this. The syndicate, combining all of the orders from their brokers collectively, tally up all of the retail orders and present it to the issuer. The issuer in consultation with their bankers decides whether the preliminary price was acceptable based on the demand. For instance, there was $83 million of bonds available collectively for 2013 and there were $86 million worth of bonds available for 2014.

If the total retail orders for each maturity year was $165 million, meaning that there was overwhelming investor demand, the issuer would look to reduce the yield since there was so much demand. If the issuer does this, all of the brokers will go back to their clients to ask if the new, lower yield is acceptable to them or not. If an issuer decides not to lower the yield and decides to issue the bonds in accordance with preliminary pricing, all of the retail investors would theoretically get a pro rata portion of the bonds that they placed an order for. Since there were twice as many orders as there were bonds available, investors will get half as much of their order as they initially wanted.

Our investor would receive $25,000 worth of the 2013 bonds and $25,000 worth of the 2014 bonds. The important thing to remember is that when you place an order during a retail order period, your order is binding meaning you will have to buy all of the bonds you ordered if they are delivered. However, if the yield or any characteristic of the bonds changes to your detriment, you will not be bound to your order, but will have an opportunity to pass. Your broker will notify you if anything changes.

California - New York - Florida - New Jersey - Texas

What is a Yield Curve?

A yield curve is a series of average yields from now into the future. This helps investors determine the yields they can earn in the market for a given set of maturity years in the future. For instance, the average yield for 2010 maturities can be 1.5%; the average yield for 2020 might be 4%. On a basic level, this allows investors to see that on average, allowing your money to be tied up for another 10 years will give you 2.5% more than if you were only willing to have it tied up for 1 year.

When the difference in yield between shorter maturities and longer maturities are very low, the yield curve is described as flat, flattening, or flattened. When the difference in yield between shorter maturities and longer maturities is high, the yield curve is steep, steepening, or steepened. Sometime the yield curve can also be inverted; this is when the yields on shorter maturities are higher than the yield on longer maturities.

Lots of factors determine the relationship between the yields that are available and time.

1. Interest rate risk - What are real interest rates today and what are they likely to be in the future.

2. Inflation risk - What is the risk of inflation

3. Credit risk - Is there likely to be any change in the credit quality of the issuer(s), both perceived and real.

4. Currency risk - Will the currency you are buying the bonds be devalued or increase in value or stay stable.

5. Liquidity risk - Will you be able to sell the security easily prior to maturity if you needed to.

Based on a variety of these factors, investors make determinations on what type of a premium that they need in exchange for what length of time. Our yield curves are here to help you see what is happening everyday in the municipal bond market.