How To Purchase Individual Municipal Bonds For Your Portfolio

[Editor’s Note: Today, we have a guest post from Full Time Finance, who graciously wrote a guest post at my request on how to purchase municipal bonds. I personally do not hold municipal bonds, so I found someone who does to give you the lowdown. My thoughts are interspersed throughout the article. -WSP]

I currently hold around $40,000 in municipal bonds split between my home state and its counties. This represents a small portion of my overall portfolio and a moderate size portion of my bond allocation. I do so for the excess return and the tax advantages. When Wall Street Physician wrote his post a few months ago on whether you should invest in municipal bonds, we discussed a potential follow-up guest post on how I purchase municipal Bonds. Below I’ll walk you through my thought process.

Municipal Bonds as One Option

The first thing to be aware of is I am not particularly tied to municipal bonds. I invest at a 20% bond asset allocation. To me, bonds include Brokerage CDs, Bank CDs, mortgage payments, treasuries, bond funds, and any other extremely low risk bond-like assets. When I have new money to place into this allocation I do so based on which option has the highest return net of their tax performance. So, for example, if I itemize my taxes my mortgage interest rate would be bumped up by my marginal tax rate. In the case of Munis they would be increased by the tax break. CDs would be valued at their return.

The highest type of return at that time gets the money. I check this whenever I am considering a contribution at one of the major bond market making brokerage houses like Schwab or Fidelity. Both have some nifty tools to compare bond returns of different types over different maturities in one screen. One side note, I don’t consider liquidity as it is not a concern for me at present. If you need your funds at a specified time you would be best served to consider this in any decision.

Municipal Bonds Risk Premium

It so happens that munis have been battered down a few times over the last decade due to fear of default. With Puerto Rico and Illinois on the verge of defaulting there was a mass exodus of buyers from the muni market giving them a risk premium beyond other low-risk assets. This risk premium is why I hold munis today. That risk premium has made these assets higher returning than others at various points. I will however point out I do not hold, nor would I hold, munis in the states actually on the brink in hopes of a high return.

[WSP: Some market analysts feared that municipal bonds would be the next “shoe” to drop during the financial crisis. Fortunately, that never materialized, but this might explain some of the risk premium. I generally think that the market is properly pricing the risk of default in municipal bonds.]

My State is Financially Secure

In fact, I only hold municipal bonds from my home state. My state is relatively financially secure, as are the counties. If your state is in financial dire straits, I would recommend against buying their municipal bonds since the point of a bond allocation is to be safe, not to take massive risk. If you want risk, buy stocks. You can check out your state’s credit rating here. Ours is AAA.

[WSP: Nice, your state has a higher credit rating than the U.S. Government.]

Why Only My State

You’ll note I do not buy municipals from states beyond my own. The reason is simple. According to the efficient market hypothesis stocks and bonds price in all available information. While not necessarily a hypothesis that holds up in the short term, it definitely holds in the long run. The logical conclusion of the theory is that the price of something tends to approach the price at which the most benefited player would buy. I.e. if I would receive 3% return and you would receive 4% from the same instrument, then it should be priced at 4% for a similarly risk rated instrument.

The ramification of that tendency is tax-free municipal bonds are always priced to reflect purchases by higher tax brackets and by those in-state. In-state municipal bonds, and occasionally neighboring states depending on laws, typically receive tax-free coupons. This is usually not true if you buy bonds of other states. This means the instate buyer gets the best rate of return including the state tax deduction, and the bonds are priced accordingly. Thus to get the best deal on a municipal bond you want to be both in a high tax bracket and in state.

[WSP: The market price of a municipal bond is the price at which someone is willing to buy it. Because of its potential tax benefits, an in-state investor is willing to buy a state municipal bond for a higher price than an out-of-state investor. Therefore, the out-of-state investor would likely be overpaying for those state municipal bonds.]

Types of Municipal Bonds

There are 3 types of municipal bonds. One type is taxable and outside the scope of today’s post. The other two are both tax-free. These are revenue and general municipal bonds.

Revenue Bond

The first of these is a revenue bond. This is essentially tied to the return of an item the government builds. For example if they build a toll road the bond is tied to and paid for by the toll. If the toll can’t cover the bond, it doesn’t get paid. I don’t invest in these as they require a lot of research to get right. Just like investing in a company you really need to understand the debt on the asset and it’s return really well to get involved here. I’ve found the data on revenue bonds is also fairly opaque. At a total investment of 40K across 12-14 bonds it’s not worth my time to dive into these bonds.

General Municipal Bond

The second type is a general municipal bond. These bonds are paid out of taxes. They are generally stated to be backed by the full faith of the issuing government organization, i.e. their power to tax. Before 2007 these were largely thought to be as risk-free as treasury bonds. In fact, technically there exists no method for states to declare bankruptcy. As we’ve seen around the world, I wouldn’t count on that. Your best defense against a default is the same as the stock market, diversification. Well, that and not investing in state on the verge of bankruptcy which is analogous to penny stocks.

Individual Bonds versus Bond Funds

The best way to diversify commonly mentioned around municipal bonds is to buy a bond fund. Bond funds behave the same way as their underlying bonds so it’s a low-cost way to get wide spread diversification across many bonds. The only problem is when you’re dealing with a smaller state like my own there may be no funds or the funds don’t cover enough different bonds to truly diversify your situation. In these cases, individual bonds might be your only solution, with the risks being to ensure you stay diversified and not get eaten alive by the spread.

Diversification

So how do I diversify with only 12 individual municipal bonds? The answer is actually quite simple. I don’t diversify municipal bonds, I diversify across all my holding types. As noted up front these bonds are a small portion of my overall portfolio. If my state or one of its counties fails, however unlikely that might be, all of my other bonds and stock holdings would still be there. Only my muni bonds would fail.

[WSP: This is one of the downsides of buying municipal bonds. Buying municipal bonds in a single state is similar to buying an individual stock.]

Spread

So what about the spread? Individual municipal bonds are a low liquidity market. They don’t change hands very often so their market spread tends to be high. The thing is you only pay a spread on used issues, as new issues are typically bought directly from the issuer. So, I try to buy new issues wherever possible. Almost all of my holdings are new issues.

Every so often I will buy used for a good return and timing. If that happens I will only buy at the money or bonds with a premium. You should not buy a municipal bond with a discount and hold it to maturity Why? A municipal bond’s discount is still taxable by the federal government at sale as a capital gain. What’s the point of a tax-free investment if you must pay taxes on it?

Hold Municipal Bonds to Maturity

Which brings me to my last point on spread. Because the spread is so poor any municipal bond I purchase I plan to hold to maturity. The trading costs on individual munis are high, so trading them is usually a bad idea.

A Final Note: Always do Due Diligence

While the above gives you a framework for understanding how I invest in Munibonds, I still do my due diligence to understand the issuance. I need to understand the structure of the coupons and things like if there is any risk of the bonds being called before I receive my return. In addition each time I invest I reassess my states financial situation for recent changes because of significant new debt issuances or business shut downs? These are the minimal you should do with any investment, regardless of the source.

As always a disclaimer, the above works for me. Any actions you take in investing are yours alone. If you do not understand the bond market I recommend sticking to bond funds as individual bonds funds are not a simplistic topic. Thanks again to Wall Street Physician for having me for this guest post.

[WSP: Thank you again to Full Time Finance for the insightful guest post. What do you think? Do you invest in municipal bonds? If so, do you invest in municipal bond funds or individual munis?]