Muni investors want to preserve capital and maximize after-tax returns, which means that they must avoid common pitfalls of muni investing.
In this article, we examine some of the most common muni bond buying mistakes and provide tips on how to hone your due diligence process to avoid them.
Keep our municipal bond glossary handy to get familiarize with the various terminologies used by the market participants.
Completing Your Due Diligence
Investors choose municipal bonds as a low risk source of tax-exempt income. Even with the high credit quality and low default rates of muni bonds, investors should follow a due diligence process to avoid making a mistake. Here are a few questions you should ask when looking to purchase new bonds.
- How much yield do you need to generate from your muni portfolio?
- What is your risk tolerance to achieve your return objective?
- What is the lowest credit rating you would be comfortable with?
- What is your time horizon for this investment?
Determining your investment objectives ahead of time is essential to avoiding mistakes. After your investment objectives have been set, you can begin searching for bonds that meet those constraints. Once you find a bond that meets your objectives, then do some work to understand the bond’s credit risk or the potential risk that the issuer will default.
The easiest way to assess credit risk is by reading a credit report from S&P, Moody’s or Fitch. The majority of muni bonds are rated by one of these agencies. For more thorough credit analysis, read the official statement of the bond issue to gain a better understanding of the issuer’s risks. This is a very long legal document so focus on key areas such as the source of revenue securing the bonds, purpose of the bond issue, bond covenants, debt structure, plans for future debt and the financial statements.
With the due diligence process in mind, let’s look at common muni bond buying mistakes you should try to avoid.
Common Muni Bond Buying Mistakes
Ignoring the Legal Structure – For muni buyers looking to maximize the yield of their portfolio, it’s natural to sort a list of bonds by their yields. By doing so, they can become susceptible to investing in bonds that rank lower in the legal structure (i.e., the case of subordinated bonds). Muni issuers often have debt structures that rank senior bonds above subordinate bonds. In most cases, the senior bonds carry a higher credit rating and yield less than the subordinated bonds. Review the legal structure of the bonds in the official statement to ensure that you understand the risk with regard to the legal structure.
Being Too Risk Averse – By nature, muni investors are not looking for a high degree of risk with their muni investment but it is possible to be overly conservative and miss out on earning a higher yield for taking on some additional risk. By investing in 10-year AA munis rather than AAA, you can gain about 0.20% in yield while moving from AA to A adds another 0.20% in yield. Market conditions change often so always consider if the additional yield you receive is worth the additional risk you are taking from the lower rated bond.
Failing to Understand Market Perception – At times, there is panic in the market, such as there was following last year’s U.S. presidential election when interest rates rose rapidly or following the comments on the potential for muni defaults by Meredith Whitney in 2010. It is important to understand why the market reacts to these events and stick with your investment objectives during times of volatility or complacency.
Failing to Complete Due Diligence – As previously discussed, completing due diligence on a muni issuer is important to avoid making a bad investment. Use a rating report from a credit rating agency as a supplement to your own research. Focus on doing in-depth credit analysis to become familiar with the municipality you are investing in.
Overpaying – It is not uncommon to see muni bonds trade at a much higher price than where the same bond has recently traded. Since muni bonds trade over-the-counter through brokers, trades are less frequent for muni bonds than they are for stocks or large corporate bond issues. Brokers mark up bond prices to earn a profit and try to maximize profit by selling bonds at the highest price they can. To avoid overpaying for a bond, use trade data provided by FINRA to see if the bond you are buying or a similar bond has recently traded. If a recent trade has been made, you can use that price to negotiate a better price with your broker.
Be sure to visit our Market Activity Section here to explore recent muni bond trades.
The Bottom Line
Setting your investment objectives and following a due diligence process is key to avoiding mistakes in muni investing. The risk of making a mistake can be avoided or reduced by spending additional time doing research on the bond documents and using the data provided by FINRA to buy bonds at fair market prices.
Check out the different ways to invest in muni bonds to stay up to date with the current investment strategies.
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