March 21, 2014

When a local government wants to construct a new toll road, school, or facility they typically have to borrow the money because they do not have the necessary funds available at that time. In order to acquire the necessary funding the local government obtains a loan from the public, this is “note” is called a municipal bond. As with any loan there is an established amount that is borrowed, an interest rate, and a specific payback date. The government then agrees to pay back the money it borrowed through revenues from the municipality or state. These revenues may come from the taxes of residential real estate, businesses or tolls. As an investor in municipal bonds you are technically the lender and can now consider yourself “The Bank.”

I recently wrote at length about why Municipal Bonds are such a fantastic investment if purchased at the right price. The current U.S tax law states investors of municipal bonds do not have to pay federal income taxes on the interest they receive from their investment. Additionally the offer gets even better because most U.S. States do not tax municipal bonds issued from their state. Wealthy individuals have been taking advantage of this opportunity for years. They simply buy them and hold until maturity while collecting tax free income .

We can all agree municipal bonds are great investments for individuals seeking tax free income. But how do you buy municipal bonds? Great question, and I’m happy to have an answer for you!

The first thing you need to know about purchasing municipal bonds is they are not like stocks. In fact they are nothing like stocks. You cannot enter them into a traditional stock ticker like you could a stock, ETF, or mutual fund. They are literally a completely different market than the traditional stock market. Just to give you an idea, the total bond market as of 2012 was comprised of approximately 38 trillion dollars while the stock market had a capitalization of approximately 19 trillion dollars.

Municipal bonds or “munis”, as they are often referred to in regards to trade are purchased either in the primary market when an issuer (the municipality) offers a new bond or in the secondary market from another investor. Primary market issues are purchased through an investment banking team underwriting the security offering, which are typically brokerage and banking firms, this is often referred to as the “Retail Order Period.” Secondary market purchases are made through brokerage firms, such as Fidelity, Scottrade, etc. The secondary market is generally where you will find your best deals as you have the opportunity to purchase munis at a discount – this is also where you will find munis trading at a significant premium due to other investors bidding the price up higher.

Your broker should offer a bond screening tool within their website, if they don’t I highly recommend you find a new broker. I have used Fidelity for over 5 years and have never been displeased with their service. In order to make them as simple as possible I am going to use the Yahoo Bond Screener that grants access to everyone.

Bond Type – Select “Municipal” then choose your state. Remember some states offer tax free income if you live in that state.

Price – I generally select “Discount” there is no reason in my opinion to pay a premium for a municipal bond. Regardless people do it all the time, they will pay $1025 for a bond that will only return $1000 to them once it’s paid off. This is known as “bidding up” the price of the bond, individuals typically do this in order to capture the income and are willing to accept less income than the original investors who paid $1,000 for the bond.

Coupon Range – I place my minimum coupon rate at 4% but in general I’m looking for at least a 5% return on my investment. You have to consider what other interest rates are currently available for the similar amount of risk. In this case I consider municipal bonds on the same level as certificates of deposit (CDs) and 10 year U.S. treasuries. The most either of these two pay in interest as of this moment is 3.276% but both of those investment opportunities tax your income.

Fitch Ratings Range – I always set my minimum at “A.” Fitch Ratings is a global rating agency dedicated to providing value beyond the rating through objective and balanced credit opinions, research and data. In short they are rating how safe and reliable an investment in a particular municipal bond will be.

Once you have compiled all this data, simply hit “Find Bonds” and you’re half way there. The next part is where you will take the time to look at each individual bond and evaluate them for investment potential based on your personal situation and risk. Once you feel you have found the bond that is right for you give your brokerage a call and give them the name of the issuer and the maturity date. They should be able to find it for you and get you on your way.

Rather than owning individual munis outright, you can buy shares of mutual funds or exchange-traded funds (ETFs) that invest in municipal bonds.

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