How to Choose a Municipal Bond for IncomeSeptember 12th, 2012 by David Waring
Many investors prefer individual municipal bonds over municipal bond funds. What attracts them to individual municipal bonds is the income stability and lack of interest rate risk when individual bonds are bought and held to maturity. (You can learn more about bonds vs. bond funds here.)
When buying an individual municipal bond there are 4 primary concerns
1. That the issuer does not default. – If you are holding a bond until maturity then as long as the bond does not default, you get your money. With the exception of calls (explained below), it really doesn’t matter what happens between the time you buy the bond and its maturity date, as long as the bond does not default. We walk you through how to reduce default risk in step 1 below.
2. Getting the highest tax equivalent yield – Normally, all else being equal, the longer a bond has until maturity the higher its yield will be. However, there are often reasons why you do not want to choose a bond with the longest maturity. We cover how to choose the right maturity in step 2 below.
With municipal bonds, your state and local tax rates, as well as whether or not you are subject to AMT, will also affect your decision. If you are in a state and/or city with high income tax rates, then you will want to choose municipal bonds from that state. If your state and/or city has low or no income taxes then you may opt for bonds outside of your state. If you are subject to the AMT you will want to make sure that the bonds you are investing in are AMT free. You can learn more about this here.
3. That the bond is not called before maturity. If you buy bonds that are trading above their face value and they are called, you will lose money. As a rule of thumb, you want to avoid buying bonds that are callable at face value in the next couple years, and are trading at a big premium to face value.
There is a quick and dirty way to prevent this situation: Avoid bonds that have a big difference between their yield to worst and yield to maturity. While you may miss out on some good bonds with this method, you won’t be surprised by having your bonds called.
Some municipal bonds are also issued with what is known as a sinking fund. A sinking fund requires the issuer to pay down portions of the debt at set intervals. It is a like a call option but is mandatory. You can learn more about callable bonds and sinking funds here.
4. That you get a good price on the bond. When possible you want to buy your bonds during the retail order period. Everyone who participates in the retail order period gets the same price and there are no markups. If you buy your bonds in the secondary market after they are issued, then you have to be very careful not to get ripped off. You can learn how to participate in retail order periods here, and about making sure you don’t get ripped off in the secondary market here.
We are going to walk you through how to think about these issues below. However, you are going to have to make several judgement calls. If you are not comfortable making these decisions, you should consider working with a financial advisor. (Learn more about how we can help you find the right financial advisor)
Step 1: Decide how much credit risk you are willing to take.
Overall the default rate on rated municipal bonds is very low. As we discuss in our article on municipal bond safety, defaults and credit ratings, historically a municipal bond is 50 to 100 times less likely to default than a corporate bond with the same credit rating.
However, this does not mean that you don’t have to worry about default risk with municipal bonds. The large majority of the municipal bond market (by dollar amount), is rated single A or better. There is a big drop off in quality with bonds rated below single A. Many smaller bond issues are also unrated, and defaults are much higher for unrated bonds. Lastly, there are many bonds which are classified as municipal bonds but do not carry the same level of safety as bonds backed by the revenues of a government or government entity.
With the above in mind you want to always make sure that the municipal bonds you are buying are:
- General Obligation bonds which are backed by the full faith and credit of the municipality that is issuing the bonds.
- Revenue bonds that are backed by a project which the residents of the issuer cannot live without. Otherwise known as “essential service” bonds, we are talking about bonds issued to fund things like a city’s power plant and sewage system, NYC subway system, water systems and the like.
You want to avoid bonds which are:
- Rated below single A
- From Puerto Rico (read about the problems with Puerto Rico’s Municipal bonds here. )
- Tobacco Bonds – (read why here)
- Real Estate or Healthcare Related - Close to 75% of defaults between 1970 and 2011 were related to revenue bonds from the housing and healthcare sectors.
- Industrial Development Bonds – these are bonds issued to fund a private project that is thought to be to the benefit of the public. Examples would be bonds issued to fund manufacturing facilities and sports stadiums. The problem with these bonds is that they are essentially corporate bonds and come with the same level of risk.
Step 2: Look at the yield curve and decide how much interest rate risk you are willing to take.
Once a week we update the municipal bond yield curve here at Learn Bonds. These are the yields at different maturities for the average AAA rated municipal bond. The bond that you are looking at may be rated lower than AAA, however the shape of the yield curve for lower rated bonds, should be very similar. This is what we care about, because we are simply trying to get an idea of how much extra yield we can get for choosing longer maturities.
AAA Municipal Bond Yields
As you can see from the above table, we are currently in a very low interest rate environment. However, there is some steepness to the yield curve, meaning that you are earning more interest on longer term bonds.
When this article was written the Average 10 year AAA rated municipal bond was yielding more than 10 times the average AAA municipal bond with 1 year to until maturity. As you go further out in time this extra return starts to diminish. For example the 10 year bond is only yielding around 2.4 times the 5 year. The 20 year bond gets you around 1.45 times the yield on the 10 year. In return for locking your money up for 30 years instead of 20 you only get .38% more interest per year. Doesn’t seem worth it.
You have to make your own judgement call here. For me, it looks like the 20 year part of the curve is the most enticing. You are still getting enough extra yield there for extending your maturities out to make it worthwhile. It also depends on your timeframe. If you are not looking to hold the bond for 20 years, then you may have to go with a shorter maturity out of necessity.
Step 3: Look for Bonds
A good place to start is the new issues with retail order periods page here at Learn Bonds. This is updated daily with the new issues which are available for purchase through Fidelity. Most of the larger online brokers can also give you access to certain new issues if you have an account with them.
If you don’t find the bond you are looking for there then you can also search the secondary market through any of the major online brokers. Here is what E*Trade’s basic screener looks like:
After running the basic screen you are likely to get a whole lot of bonds to look through. In the upper left hand corner of their results page is the advanced screener. You can use this to filter on a wide variety of variables, including the type of bond and callability.
Step 4: Choose the bonds you like
Once you have taken into account the factors outlined above, we are fans of Peter Lynch’s “invest in what you know” philosophy. When possible you want to buy bonds issued by municipalities or for projects that you will not have a hard time following. For example I live in NYC so if I purchase bonds issued by the MTA I am likely to know if they are running into financial issues which may cause me to want to sell the bonds.
Lastly you want to check the ratings reports for the bonds you like. The major online brokers normally give you access to either the moody’s or S&P summary ratings reports. The Moody’s reports are far better, so we recommend using a broker that has those reports available (E*Trade, Ameritrade, and Schwab all do).
When looking at the ratings report, you want to make sure that, at a minimum, the bond and issuer are not on watch for a downgrade. Ideally, in addition to not being on watch for a downgrade we would like to see that the bond has actually been upgraded recently. If you want to take things further than this read our article “Do it yourself Credit ratings”.
This lesson is part of our Free Guide to the Basics of Investing in Municipal Bonds. Continue to the next lesson here.