Executive Summary:

Municipal bonds are important assets that are an essential part of many investors’ bond portfolio. This article will discuss Municipal bonds and the way they can work in a diversified investment portfolio.  Most of this article will focus on the municipal bonds markets and the most efficient ways to build a diversified portfolio.  First, a broad look at fixed income products is discussed.  The asset classes that are most commonly invested in are bonds.   This article will also touch on the benefits of municipal bonds as they relate to investors and the overall health of the economy.

The term “fixed income” describes the return received from purchasing an investment instrument within this asset class.  The return is usually fixed over a period and the purchaser receives interest in the form of a coupon on a fixed term.  The terms for payment of these products can be daily, weekly, monthly, quarterly, semi-annual, annual or at one lump sum.    Most bonds pay interest twice a year.  When a bond is issued, the face value (which is the issue amount in dollar terms) is called the Par value.  This is usually $1,000.

The fundamental goal behind a fixed income product is paying investors interest for principal that is lent to a borrower.  There are a number of fixed income products, which include bonds, which are issued by government or municipality in an effort to borrow money.   Think of a bond as an IOU with a serial number.  Bonds where created in 1800’s as a way to raise capital. When a company or municipality wants to borrow money, they issue an IOU (bond) that will pay investors a fixed amount of money during a specific period.  The Securities and Exchange Commission oversees issuance of bonds but does not regulate municipal borrowers.

For example, when an investor purchases a Municipal bond the investor purchases a financial product in which a loan is made to a state or municipality.  Municipal bonds can be purchased directly from the government through a broker, although in most circumstances, investors purchase bonds in the secondary market through brokers.

When an investor purchases a Municipal Bond, the investor is entitled to the interest that is associated with the bond as well as the return principal used to purchase it.  If the bond is held to maturity, the bond buyer will receive their principal back.  The market risk associated with this type of debt product is principal risk and is subject to gains or losses based on the movements within the secondary market.

Bond prices move as a function of interest rates, capital flows, as well as, the solvency of the municipality.  Interest rates on Municipal bonds will move up and down on a daily basis and usually the longer the term of the bond the greater the fluctuation of the bond’s value.

A ten-year Muni matures in 10 years.  Short-term bonds have a maturity of 1-3 years, while intermediate-term bonds have a lifespan of 4-12 years and long-term bonds have a life span of 12-30 years.

The price of a bond moves in the inverse direction of its yield.  This means as the price of a bond moves higher say from 100 to 101, the yield on the bond will move lower, say from 4% to 3.75%.  The yield describes the interest rate return for that individual bond.

As the price of the bond rises, the yield on the bond drops.  This inverted correlation also means that when yields are at their lowest, the value of the bond is at its greatest.

For example, imagine you purchased a 10-year bond, which has a semi-annual payment of 6% of the notional value of the purchase amount at par (which is 100).  If interest rates in general rise, and in turn, the effective yield to maturity on the 10-year bond will rise from 6% to 6.5%, and the price of the bond will fall below 100. Price changes do not matter if you hold a bond to maturity.

Some bonds are callable.  This means that the bond issuer can re-purchase the bond after a specific amount of time at par.  An investor should check their yield to worst call, which will reflect their worst case interest rate.

Municipal Bond

Municipal bonds or Muni bonds are fixed income products where a municipality is the borrower of the money.  This could include a city or state, or village.  Generally, municipal bonds are used for specific projects, but they also can be use for the general obligations of the municipality.  Projects could include; utilities, universities, hospitals, cities, states, schools, bridges, stadiums.

Municipal bonds are generally more risky that US Government bonds, but less risky than corporate bonds.  The default rate on high quality AAA municipal bonds has been below one third of 1%.

Individual investors own an estimated 66% of all municipal bonds through either individual issues or mutual funds. Insurance companies own about 15% of municipal bonds, while the balance is owned by banks and other investors. The entire municipal bond market is estimated to be approximately $2.8 trillion.

Ratings

Similar to the way companies are rated by the three large credit rating agencies, Moody’s, Standard & Poor’s and Fitch, Muni bonds are also rated to give investors an idea of the credit quality of the bond.  The credit quality is the likelihood that the bond issuer (the group that is borrowing money) will pay their loan back.   These ratings are a good guide to determining the credit quality of a bond, but are not perfect.  The market was rocked in 2008 by a credit crisis where the rating agencies mislead investors based on their assessment of sub-prime and alt-bonds.  The rating agencies were overly optimistic with regard to their ratings and billions of dollars where lost in the economic downturn.  The table below shows the different ratings listed by the three major ratings agencies.

Best quality for each of the major rating’s agencies is AAA.  When a bond falls below an investment grade rating of a major bond agency, the bond is considered “junk” (non-investment grade).

2010 Ratings Change

In 2010, many Muni bonds received ratings upgrades to make ratings more comparable to other types of bonds like corporate bonds. This change for simplicity sake, caused 82% of the Muni bonds to be rated AA or higher by Fitch ratings, up from 52.7%. This and inflation of grades and made it hard to come here bonds based purely on ratings.

2012 Ratings Change

S&P changed its ratings methodology for general obligation bonds issued by towns, cities, and counties in early 2012. These change does not effect school districts and was designed to enable better comparisons between US local government ratings and all other ratings. As a result of this, 32% of these ratings increased, while 2% decreased.

This new rating system imposes a cap on certain negative factors. If there is weak liquidity than the cap would be A- or BB+. If there is sustained high fund balances, ratings could increase by a notch or two.

Lower quality bonds come with higher yields.    The more likely the municipality is to renege on their payment, the higher the borrowing costs, hence the higher amount needed to be paid to entice investors.

Tax Advantages

Municipal bonds have a tax advantage feature that makes them the most popular bonds amongst affluent individual investors.  The majority of the bonds that are issued within an investors home state are exempt from Federal and State (and local where it applies) taxes.

For example, if an investor who lives in NYC, purchases a muni bond that is issued by the state of NY, he will not have to pay taxes on the income received from the bond, making it a tax free bond.

This benefit does not apply for out of state bonds.  If the same investor purchased a New Jersey municipal bond, the investor would have to pay the State income tax on the interest income, but not Federal taxes.  Occasionally, there are bonds that are tax free in more than one state.

Some Commonwealths, such as Puerto Rico, give both the State and Federal exception regardless of where the bonds are purchased.  National municipals also provide Federal tax exception, but not State tax exceptions.

When an investor purchases a fixed rate Muni bond, the investor will receive an annual return that is specifically tied to the interest rate stated when purchasing the bond.  If an investor invests $1000 as principal into a 5-year Muni bond at a coupon rate at 5%, the investor will receive interest on the principal at 5% per year.  If the interest were calculated once a year, the investor would receive $50 of interest at the end of the first year.  If interest is calculated at a time of less than 1 year, for example every month, the investor would receive interest on the interest invested or a compounded returned.  In this example, the rate is fixed at 5% and remains the same for the life of the bond.

Build America Bonds are new bonds created in 2009. They are taxable Muni’s partially sponsored by the US Government. These bonds were created by the Obama administration to help local governments raise capital in the midst of the 2008 Financial crisis. These bonds receive a 35% federal subsidy on the interest rate, making them very popular with cities and states. Build America Bonds are popular with pension funds and overseas buyers who do not benefit from municipal bonds tax-free status. Approximately 10% of Build America bond buyers are foreign-based. Some believe that overextended states like California and Illinois, have used these bonds to further overextend themselves. Over hundred $150 billion Build America Bonds were issued between the program start in April of 2009 through early November 2010. Almost $30 billion worth was issued by California. Over $17 billion was raised by New York. Issuance of Build America bonds hit a peak at the end of 2010, as the program being wound down. Local governments issued billions of dollars of bonds to lock in these lower borrowing costs.

Yield Curve:

The yield curve represents the interest rate that investors are willing to pay for a particular duration of a bond.  Duration is the length of time that the issuer wants to borrow money.  In general, the longer the duration of the bond, the higher the yield needed to attract investors.

The sample graph below depicts national municipal bond yields as a composite.  As the duration or maturity of bonds increases, the yields on the bonds also increase.  The reason for this is that the longer investors loan money to a municipality (any other entity), the more there is a chance for the borrower to default or go bankrupt.  Longer maturities normally have a higher interest rate, which means the municipality has to pay more interest on a bond.  The yield on the 30-year duration is larger than the yield on the 10-year duration, which in turn is larger than the yield on a 5-year.  The shape of the yield curve shown is referred to as “normal”.  Occasionally, when interest rates are rising, or when investors are nervous about the economy, the shape of the yield curve becomes inverted.  This means that the yield in the 2-year duration is larger than the yield in the 10-year duration.

Why buy bonds?

Bonds are one of the many investment choices that are available.  The most widely held investments are fixed income products, equities, commodities, currencies, and real estate.  Most of these products vary in their valuation, depending on the current supply and demand and the current economic environment.

Diversification

One very important way to generate consistent returns in the capital markets is to have a portfolio that is diversified.  This means that you do not want to put all your eggs in one basket.  Holding a portfolio of just one class of investments, such as technology stocks, created great wealth in the 1990’s as the NASDAQ made an all time high in late 1999, but during the crash that ensued from 2000-2003, you would have lost 50% of your investment.

By adjusting your holdings to own numerous asset classes, you can build a portfolio that has consistent returns over a long period. The ultimate goal in any diversification strategy is to improve investment performance while mitigating risk.

Bonds make up an important portion of a diversified portfolio.  Bond prices are generally uncorrelated to stocks, or commodities, and give an investor an opportunity to generate revenue and returns via income as well as capital appreciation.

An investor who invests for income should diversify his or her holdings among numerous types of bonds.

This diversification usually means owning numerous types and durations of bonds.  This would include short-term, medium-term and long-term bonds.  Investors can also diversify their bond holding by purchasing different types of bonds; municipals bonds, corporate bonds and, sometimes, high-yield (“junk”) bonds.  Diversify a muni bond portfolio by purchasing bonds from numerous states or municipalities.  This way, an investor has reduced the risk that one city or state’s problems will affect his entire bond portfolio.

Tax Benefits

Municipal bonds are generally more efficient for individuals who are subject to a high tax liability.  Investment vehicles that are already tax exempt from Federal and State taxes, such as IRA’s and 401K’s or 529’s are not designed to benefit from the tax exempt function of municipal bonds, so it is unwise to house munis inside these accounts.

Municipal bonds are most beneficial to individuals who are in a high tax bracket.  The best way to understand how this tax-exempt status can be beneficial is by looking at an example.  An individual, who is currently living in NY and is at the top income bracket, pays 35% tax on Federal income and 7% on State income.  For a NY state municipal bond that has an annual yield of 6%, the return is even greater.  The 6% tax-free yield would be equivalent to a return of 10.4% on a taxable corporate or Government bond.  On $1,000 dollars a 6%, municipal bond would pay the investor $60 per year.  A corporate bond that has a coupon on 10.4% would pay an investor $104 per year.  After 35% Federal tax and 7% State tax, the investor is left with 58% of the $104, which is $60.  Most times, it will be very difficult to find a Government bond that pays 10.4%.  This would mean that the investor would need to invest in a high yield “junk” corporate bond, which would have a much higher credit risk, and likely a higher market risk.  The alternative, which is municipal bonds, pays an attractive after tax yield, with a much lower market risk.

While it is attractive to receive double tax-free interest, investors need to factor in the stability of their home state when purchasing municipal bonds. It may make better sense to invest in national Muni funds rather than a single state Muni funds.

The example below shows equivalent Municipal bond yields given two specific tax brackets.

The formula that can be used to determine the equivalent tax free municipal bond yield is as follows:

Muni Bond Yield = Taxable Yield * (100% Federal Tax Rate)

For the example above 4% = 5.5% * (72%) = 3.96% with zero state tax rate.  To factor in State taxes, you can use Vanguard s Calculator

For affluent seniors or those moving close to retirement, municipal bonds offer relative safety with a high after tax income.

Another benefit of municipal bonds is that they help stimulate the economy.  When projects are announced by a municipality, they generally will assist in the process of creating jobs.  The municipal bonds that are used to finance these projects have the direct effect of stimulating the local or state economy.

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