At this point you may be asking yourself…
What is a Municipal Bond?
- Professional Definition — A debt security issued by a state, municipality or county to finance its capital expenditures. Municipal bonds are exempt from federal taxes and from most state and local taxes.
- My Definition — Sometimes not all public projects can be funded by tax revenue. So when a state, city, county or town wants to build public projects such as schools, bridges, highways, etc and needs to raise money, they take out a loan from the public in the form of “Municipal Bonds.” Oh and by the way you don’t have to pay federal taxes on the payments you receive from these bonds and in some cases no state taxes as well.
Here is an example of a municipal bonds:
Cowboy County would like to build a new road to their 5 year old football stadium that would help alleviate traffic. The road is going to cost $10 million to construct and the county is willing to pay 5% interest on a 10 year loan. (Typically Municipal Bonds come in increments of $1000 or $5000, for this example we will use $1000 increments. Therefore Cowboy County will issue 10,000 individual shares/bonds that will pay a 5% dividend.
The Problem with Municipal Bonds
As you know I am a huge advocate of conducting your own analysis of individual companies/businesses but municipal bonds are a completely different industry than securities. You are in theory acting as a bank, lending money to the county for a set period of time while you collect interest on your money.
All in all Municipal bonds can be COMPARED TO certificates of deposits (CDs). The difference is you can sell your bond at anytime on the open market (we’ll get into that another day).
The huge problem I see with municipal bonds is their minimum investment increments. At $1,000 & $5,000 you would need a pretty hefty portfolio in order to be substantially diversified and build a sizable position. Don’t get me wrong, municipal bonds are some of the safest investments you can make especially when you have a reputable credit agency rating their bonds. However, nothing is guaranteed when it comes to investing.
So if I don’t have $1,000 to invest in municipal bonds what are my other options????
Invest in a Bond Fund
You can buy municipal bonds that are insured against default and collect a super-rich yield. For example, the fund I’m looking to own is the Invesco Value Municipal Income Trust (IIM). This fund holds investment grade bonds from several states, including California, Texas, and Colorado. It spreads your risk across a variety of bonds and right now it’s paying a 5% yield/dividend TAX FREE!!
But before you go rushing into something you ALWAYS need to know the VALUE of what you are investing in. Mutual funds and Exchange Traded Funds use what is called “Net Asset Value” (NAV) in order to value their shares. In short, NAV calculates all the assets in the fund and subtracts the liabilities (fees, expenditures, etc). You always want your fund’s NAV to increase or stay constant, NEVER decrease. With that said, when purchasing a mutual fund or ETF you would ideally like to purchase at a discount to NAV instead of a premium.
Here is a the NAV history of Invesco Value Municipal Income Trust from 2005 – 2012
As you can see for the past 7 years the NAV has floated between $12 – $17, with the majority of that time spent between $14 – $16. Needless to say that the NAV for this fund is pretty stable.
My Plan?
To invest $10,000 in this fund before the end of 2013 and reinvest every single dividend for at least the next 18 years. (Remember that these are monthly payouts which will boost my dividend reinvestment plan tremendously)
Here are the results if I never invested another penny and if the dividend didn’t increase.
Not too shabby for a sleep well at night investment!
Things to Remember
This is not an end all be all investment strategy. While we are in a world of nearly 0% interest rates and an inflation rate of 3.5% a tax free 5% income stream is nothing to balk at. But let me be clear, I could do much better with individual securities over time. My main objective with this fund is to preserve my capital while generating a tax free income stream.
Here are a few ideas/instances I can see this fund being implemented with familes:
- Revenue generating savings account: Take that monthly savings allowance and contribute it to this fund. If you ever decide to buy that new gadget you’ve always wanted you can use the monthly dividends to pay for it.
- Gift giving account for relatives: My mom literally hounded me for weeks about wanting to setup a savings account for my daughter. I told her this would be a much better option. My wife and I plan to put 50% of all cash gifts given to our daughter into this fund.
- College Savings Account: From the day your child is born you can start contributing to this fund in order to help pay for college.
How would you use a fund like this? Do you have any funds that are similar to this one?
December 26, 2012 at 11:51 am
How are munis comparable to CD’s? I don’t think they are, since there is a whole slew of risks on takes on with munis opposed to a CD. Especially considering the fund you specifically mention has a longer avg duration than most bond funds these days (almost 7 years!) and far from a high credit rating. So, the real question is, not how these compare to CD’s, as you suggest, but how these compare to investments of a similar risk level? Furthermore, if you don’t live in a state with high income tax, and/or you aren’t in the 25-28% tax bracket, are you better off paying taxes in the first place?
December 26, 2012 at 12:23 pm
They are comparable as you are lending money for specific amount of time and receiving a payment in return. Are there risks with Municipal Bonds?? Absolutely, but there are also risks with CDs. The fund I mentioned has an inception date of 1993, I could only gather information for the last 7 years while I was writing the article. The bonds in this fund are extremely safe with 90% of their portfolio rated as A and above!
To answer your question, this fund is significantly lower risk than the majority of securities that currently pay a 5% dividend. FURTHERMORE, how can you even begin to argue that a federally exempt dividend isn’t a huge bonus?! Regardless of your tax bracket.
December 26, 2012 at 8:33 pm
Greek bonds are offering between 17-18%. So, by your definition you can compare those to a CD because you lend them money for a certain amount of time and you receive a payment in return. Why not write an article about putting your money in Greek bonds opposed to a CD? Of course, my argument was never about how these instruments function, but rather investments should be compared according to a risk profile. The answer to why people don’t invest in Greek bonds instead of CD’s is because it is riskier. So is what you suggest. It’s irrational to say a bond fund is better than a CD just b/c of the yield, there is additional risk with the bond fund (which you pitch as both having risk so we just lump them together right?).
You’ve also fallen into a statistics trap. Sure, 90% of the holdings have an A rating or better, but the weighted average rating is BBB. In other words, pretend they have 10 holdings, 9 of them are A or better and one is BB. So, it is true to say that 90% of the holdings are A rating or better. In actuality, of the 9 which are A or better, they have only invested $1. In the one that is BB, they invested $100. What is the true rating of your money in the fund? And OF COURSE, since you are blogging about this, you already know there are other risks to bond funds than just the credit/default risk.
Finally, muni bonds are often for those in the highest tax brackets (and/or a state which has a high income tax). It’s well written about online. You should compare after-tax yields for investments of similar risk (which hopefully you understand by now). If it was a slam dunk for everyone to invest in tax managed funds, all the funds would be tax managed (with funds just to be held within IRA’s, 401k’s etc). But, it is actually the other way around – most people don’t benefit from tax exempt funds. You can read about the calcs (but don’t forget to compare to a similar risk investments – otherwise I’ll keep bringing up those Greek bonds!). http://www.bogleheads.org/wiki/Vanguard_Limited_Term_Tax_Exempt_Bond_Fund_Tax_Distributions
December 26, 2012 at 10:59 pm
You have got to be kidding me.
First off, I highlighted “Compared To” in bold in order to emphasize I was using it as a point of reference, NEVER stating that municipal bonds are like CDs.
Furthermore Greek bonds are yielding 17-18% because they are more than likely going to default and by the way I am 100% certain their credit rating isn’t above A. No I did not fall into a statistical trap I am not sure what math you are calculating but I would urge you to check it again or read the funds prospectus.
Second of all you are too eager to put words in my mouth, I NEVER stated that Municipal bonds were better than CDs. Go back and read my article and tell me where you read that please.
You talk about risk profile, when bond holders are the FIRST in line to collect payments. The municipalities have the OBLIGATION to pay you. If they do not then town goes bankrupt. How often do you see that????
Lastly, you come to my site (which is 100% free by the way) and don’t offer constructive criticism but insinuate that I am incompetent and misleading my followers, in which I take a huge offense. The title of this post is “How I Invest In Municipal Bonds” not everybody else. For my particular situation the tax benefits make sense AND it certainly can benefit others in different tax brackets. A 5% yield tax free is unheard of in this day and age. The fact that you continue to insist it’s no big deal tells me you need to be a follower to my site. Please allow me to show you some facts.
A tax free 5% yield for an individual:
In the 15% tax bracket is = 6%
In the 25% tax bracket is = 6.5%
In the 28% tax bracket is = 7%
In the 33% tax bracket is = 7.5%
These numbers may not seem like a big difference but as a Personal Finance “Watchdog” I’m sure you “already know” they will make HUGE difference when compounded over the long term.
I look forward to seeing you on my site more often =)
December 26, 2012 at 5:35 pm
After reading your article and comments above, it seems like a muni bond is a fairly safe fund and the return is decent. Great food for thought!
December 26, 2012 at 11:11 pm
Glad I could share something new with you. Whenever you have free time I would urge you dive into municipal bonds a little deeper I think you’ll find huge opportunities.
December 26, 2012 at 7:41 pm
Comparable, perhaps, but CDs have the FDIC standing there ready to support a bad bank. You had ~31 municipal bankruptcies since 2010. (Of course, in many instances you may get your money back, even if it is locked up for a while.)
Still, I live in California and I know the risk of BK is higher here than in other areas, yet I still trade in and out of the Schwab California Muni Fund (SWCAX). I used it to dump down-payment money, and now I use it as almost a catch all when I run out of tax advantaged accounts. The fat returns boosted by the massive tax here makes those returns golden, haha.
December 26, 2012 at 11:10 pm
California is a state that is not ideal for investors with those high tax rates. But it sounds like you have a well thought out plan to capitalize.
Yes CDs do offer FDIC insurance which is great. I wish Municipal bonds had the same
That’s why I only invest in funds with ratings higher than A.
Not sure if you saw Meridith Whitney on 60 minutes about a year ago talking about the crisis some towns are facing with bankruptcy but it spooked A LOT of investors out of municipal bonds and allowed for savvy investors to capitalize.
December 26, 2012 at 10:35 pm
Thanks for the information. I wonder if I have enough diversification at times, and when I am not so tired, I will reread this post and see if this type of investment is something I would consider adding.
December 26, 2012 at 11:13 pm
One of the hardest things for me to learn as an investor was that I simply can’t capitalize on all the great opportunities out there. My suggestion, stick to what you know, become an expert at it, then once you have mastered that move on to a different strategy.
With that said I would definitely urge you to put municipal bonds on your to do list when you finally have some free time. If only there were 6 more hours in the day right??? =)
December 27, 2012 at 3:12 pm
Marvin, Thanks a lot for the idea. I knew generally what the bonds are and wanted to invest into municipal bonds in the past, but the high price needed to invest always discouraged me. Apparently I didn’t somehow got the idea that I could invest purely through the mutual fund or ETF. So thanks for the tip. I added IIM to my watch list and definitely will review and invest in it as part of my diversification strategy.
December 29, 2012 at 1:25 pm
Glad I could help. I had the same problem although 10-15 years from now when my portfolio is much larger I will begin to make the move from equities into the bond market. That is where all the “REAL” money is at =)
December 28, 2012 at 11:56 am
Great informative post Marvin! I think many don’t know the benefits of munis and how they work. While rebalancing I am seeing the need to add in more of a fixed income component to our portfolio. They don’t have the sexiness of stocks, but can be good producers if you get in the right fund.
December 29, 2012 at 1:27 pm
You nailed it John, municipal bonds are not sexy and are not generally a popular topic amongst investors. But these things can be the corner stone of a portfolio if you manage them right.
December 28, 2012 at 6:54 pm
I’ve avoided since they assume a tax-adjusted return based on top tax rate. Since I’m nowhere near it, I assume I’m not getting paid for the cash/risk and I could do better elsewhere.
December 29, 2012 at 1:29 pm
I’m not too worried about the actual return on my money due to the fund’s steady NAV. My main focus is the payout.
December 29, 2012 at 10:37 pm
I don’t know much about municipal bonds and probably won’t be investing in any locally (hurricane Sandy did a massive amount of damage in our area). Or maybe now is a better time to invest in municipal bonds because the feds will be pumping a lot of money into the economy to fix all of the damage?
December 30, 2012 at 1:55 pm
Bonds are some of the safest investments you can make. Please keep in mind you need to do some research if you invest in them individually, but in order for you to lose money on your investment the municipality would have to declare bankruptcy. Of course some towns have declared bankruptcy and in turn defaulted on the bonds issued but the number of bankruptcies has been miniscule.