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.
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?