Buying Municipal or State Bonds

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Last week I was volunteering at Meals on Wheels when one of the other volunteers, Cheryl, asked me about buying state bonds. Until last week, I hadn’t really given it much research because the idea of buying individual bonds was never tremendously appealing. There is a big barrier to entry when you’re buying individual bonds and it’s with the minimum purchase amounts. In Maryland, if you buy the bonds from the state through a broker, your minimum buy is for $5,000 and your purchase must be in increments of $5,000. However, you can buy them in smaller increments on the secondary market so I thought I’d give it a look for this Foundation series post on buying municipal and state bonds.

Basics of Bonds

If you aren’t familiar with what a bond is, don’t worry because you’re not alone. Fortunately, it’s a fairly simple concept. You can think of a bond as an I.O.U. When you buy a bond, you are lending the issuer, such as the government, municipality, corporation, etc.; money. In return for the loan, they will pay you a specified annual interest rate, the coupon rate, for the life of the loan. When the bond matures, they will pay you the face value of the bond, known as the principal.

Bonds will always be given a rating by one of the ratings agencies. Think of it like a credit score, but for the government or municipality. Bonds typically come in three time horizons – short term bonds for less than 2 year maturities, intermediate-term bonds that go from 2 to 10 years, and then long term bonds that are 10+ years.

Finally, and this is only a small wrinkle, bonds can also be callable. This means that the bond issuer (the state) can opt to pay off the bond before it matures according to the rules on the bond. For example, the bond issuer may say I will sell you a 10 year bond but in five years I want the right to call the bond for face value. For the next five years, you’re guaranteed the interest payments but after five years the bond issuer can opt to buy the bond back from you.

This is a very simple explanation on bonds, if you want to learn more (such as proper valuation), you should check out Investopedia’s bond page.

Tax Benefits

The interest you earn on state and municipal state bonds is usually federal income tax free. For state bonds, the interest will usually be state tax free if you live in the state that issued them. There are a few exceptions and it always pays to check with your state to confirm the tax status. In some states, where there is no state income tax, you could buy any municipal or state bond and still have it be state tax free because your state doesn’t have a tax!

Does this matter much? Yes! If you’re in the 25% tax bracket, a tax-free investment yielding 5% is equal to a taxable investment yielding 6.66%. When you add state income taxes into the mix, you’d need to find a taxable investment yielding more in order to be equal to a 5% tax-free investment.

Why Do Bond Prices Change?

You might be wondering why someone would be willing to sell a $100 bond for less than $100 (discount) when you have a guaranteed payout each month? Or why would someone demand more than $100 (premium)? The primary reason has to do with interest rates. When interest rates go up, the value of a bond goes down. It goes down because investors are always comparing their investments with the “safest” investments, Treasury bills.

If I can invest my money at 3% in a Treasury savings bond and be 100% safe, maybe I want 5% for the slightly riskier state bond. If the Treasury savings bond’s interest rate goes up, my bond is less valuable because my bond’s interest rate stays the same. Let’s say I want to sell my bond and a buyer sees the Treasury bonds at 4%, now they want 6% out of a state bond. Since the interest rate on the bond can’t change, the only thing I can do is sell my bond for less to give them a higher effective interest rate. So, I would sell my $100 bond for $83.33 because the $5 interest payment (5% of the $100 face value) is 6% of $83.33.

There are many other reasons why bond prices might change, such as a change in the creditworthiness of a state, but those are harder to quantify as cleanly as interest rate changes.

Finding Bonds

There are several ways you can invest in bonds. The easiest way is to invest in a bond mutual fund. The bond mutual fund will invest in a variety of tax-advantaged bonds, much like how a stock mutual fund invests in a variety of stocks. Vanguard has tax-exempt bond funds beneficial to California, Florida, Massachusetts, New Jersey, New York, Ohio, and Pennsylvania residents. Go to Vanguard’s fund listing, chick only “Bonds” under Asset class, then Tax-exempt under Tax-efficiency and you’ll see thirteen listings. The other funds listed are tax-exempt from federal income because they invest in federal bond products.

The other way to invest in municipal or state bonds is to purchase individual bonds from the government. You will need to check with your state Treasurer to find out what you need to do to buy your bonds but in general you will buy bonds through a brokerage. For example, in Maryland, you can’t buy bonds directly from the state, it must be done through a broker. In other municipalities, if you have enough money, and are willing to invest it, this is probably one of the best ways because you get them directly from the state.

Finally, the last way is to buy bonds on the secondary market. You can find bonds by using a Bond Screener, much like how you’d use a stock screener. I recommend that you use the Bond Screener in your broker account. With Yahoo! Finance’s screener, you can filter on a variety of characteristics. When buying it on the secondary market, the key figure to look for is the Yield To Maturity. Bonds will have a Face Value of $100, meaning you get $100 when the bond matures, but when you buy it on the secondary market you will pay more (premium) or less (discount) than $100. This will mess with the interest rate because interest is paid out on the face value. Yield to Maturity will take all that into account.

If a bond has a 5% coupon rate and a $100 face value, then you get $5. If you pay $200 for the bond, your effective coupon rate is actually 2.5% because you get $5 and invested $200. Yield to maturity becomes important because it factors in the fact that you paid $200 and will only get $100 when the bond matures.

Once you’ve found a bond, simply fire up your favorite broker account and buy it. E*Trade charges a commission of $1 per bond (minimum $10, max $250). Remember that bonds will have a minimum trade quantity (if you buy them from Maryland through a broker, it’s 50, or a $5,000 investment) so don’t expect to be able to buy just one. I did a quick search in E*Trade for Maryland municipal bonds with a YTM of at least 3% (click to expand):

The first listing is for a “Maryland St Health & High” bond, which a Maryland State Health and Higher Education bond. It matures in 2013 and the current price is $95.935 and there are 75 available, with a minimum order of 25. The coupon rate is 4.00% but we can, for the most part, ignore that because we know that’s 4% on $100… but the price is less than that (it’s at a discount).

That’s it!

That’s state and municipal bond investing in a nutshell… a pretty big nutshell. Hopefully I’ve captured all the important points but if you noticed something I omitted or got incorrect, please let me know!

{ 20 comments, please add your thoughts now! }

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20 Responses to “Buying Municipal or State Bonds”

  1. Great article Jim. I’ll add that when interest rates change the values of existing bonds move up or down. Newly issued bonds are still sold at face value when they are issued.

  2. Jacqui says:

    I fell in love with buying bonds on E*Trade about a month ago. No, it’s not for everyone due to the high minimums, but if you can save up chunks of cash it can be a great deal. Under some circumstances, they can even be a good alternative to CDs.
    But even these relatively ‘safe’ vehicles should not be purchased with money you absolutely could not live without. The risk of non-payment is low, but not none.

  3. Wow, very detailed post. I have to admit, I know very little about municipal bonds, but this has done wonders on getting me up to speed.

    Although I’m not investing, something really appeals to me about these type of bonds. I think they speak to my ultra-conservative side.

  4. Matt Fyffe says:

    I’m still confused by parts. So if I buy one of those 4% bonds for 95$ NOW, with an expiration date of 2013, in 2013 I will get 100$ plus how much extra from the 4%? Is that 4% an amount of interest accrued yearly or over the whole period?

    Basically, do I get 104$ in 2013 or do I get 116$ because those 4 dollars accrue each year in interest.

    • Jim says:

      In 2013, you will get $100. Each pay period, which can be monthly, quarterly, semi-annually or annually; you’ll receive 4% APY (not 4% each period, but enough such that it’s 4% a year).

      Did that make sense?

      • Matt Fyffe says:

        Okay I think I got it.

        So if I buy a 100$ municipal bond that matures in 2013 with a 4% rate, I’ll be getting that 4% rate every year until 2013.

        So 2009 – 4$, 2010 – 4$, 2011 – 4$, 2012 – 4$, 2013 – 4$ for my 100

        That makes sense and is about the standard rate (though better than most right now!) I just wanted to make sure I hadn’t misread before I committed to anything.

        It sounds like a good deal though and one I might try.

  5. Patrick says:

    Municipal bonds really make sense if your state has a high tax and you are in a high tax bracket. I think they are a great idea for a fairly safe investment that give you tax-free returns.

  6. Brad Harbach says:

    Great introduction article Jim. Lots of good information to help people understand not only what a bond is, but specifically what advantages muni bonds can offer over taxable corporate bonds.

    I think it is important to note that individual investors should not be purchasing INDIVIDUAL bonds. Purchasing individual bonds, like purchasing individual stocks, is speculation and not investment.

    I’ve read countless articles over the last year of people’s “SAFE” bond investments being wiped out. I wrote a blog on this last week and included a quote from perhaps the most wise investor of the past 100 years – Benjamin Graham.

    “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

    Buying individual bonds, especially those that are not properly secured, is purely a speculative play and should be avoided.

    If one is to include bonds in their asset allocation, which most will, the vehicle should be a bond fund. Vanguard offers several muni bond funds that would be much better suited for the individual investor vs. purchasing individual bonds becaused of the reduction in risk diversifying your money over a fund of bunds offers you with very little impact on your return. An added benefit of these bond funds is their increased liquidity and lower transactional costs vs. an individual bond.

  7. Jim says:

    Very good overview post Jim.

    Couple things I’d emphasize.

    AAA/AA rating is the best and people should probably stick to that level. Once you get below AA the risk of defaults starts to go up a lot. B rating or below starts to hit ‘junk’ status and the default rates there are fairly high.

    If you’re looking at buying individual bonds then it is important to diversify over multiple bonds from different sources. Even though the risk of a municipality defaulting on a bond is usually very low it can and does happen. So its best to make sure your money is spread around to lessen the exposure to a potential default.

  8. daniel says:

    thanks for the informative post!

  9. Allen says:

    Municipal bonds are the second safest bond investment in the world behind US treasuries (if held to maturity). With individual Muni bonds an investor can get certainty. Locked in interest rate paid twice per year, with insurance a guarantee (FSA, AGC and BRKA) a AAA rating, guarantee of their principle if held to maturity and margin-ability. With mutual funds you get non of the above: no guarantee of principle, no guarantee of interest if held to maturity and they must be held at least 30 days to be marginable. One may also invest in Muni bonds through Unit Investment Trusts or closed end funds that invest in muni bonds or other muni funds that trade on the NYSE. Some of these UIT’s (if they own individual bonds) have certainty of income and eventually all the muni bonds will be called or mature.

  10. The first thing to remember about munis is that they make sense only if you are in a higher tax bracket. Vanguard’s Intermediate Bond Index Fund (VBIIX) currently yields 4.57% while its muni equivilent (VWITX) yields 3.45%. At a 25% marginal rate, that’s basically a wash. Higher and munis start to look interesting.

  11. Gerry says:

    You left out LOTS of important info.The bond you mentioned is rated Baa3 which is only one downgrade away from being categorized as high-yield or junk. The actual yield to maturity in 2013 is 5% because if they pay off at 100 you have the profit since you bought it at a discount. The other bonds listed from MD or either taxable or subject to the AMT which means the interest is taxable if you pay AMT tax.

  12. Carole says:

    Munis can also play a role in estate planning. I live in the same state as my parents did, and the munis I inherited are providing me with an average yield of 4.75%, with no federal or state taxes.

  13. thomas says:

    Excellent post! I’ve definitely wanted to learn more about these types of investments. Thanks for the info!

  14. MoneyEnergy says:

    What Thomas said; I’ve invested in bond funds, and bought individual government (Canada Savings Bonds), but don’t know much about corporate or municipal bond investing, so this should help give me a good idea.

  15. Jeff Redshield says:

    Nice article. I will add some extreme important facts.

    Munical Bonds can be Revenue or General Obligation. You need to get the General Obligation because these are backed by a Govt ability to tax the people making default virtually impossible as long as their lives people in the municipality to tax.

    Now the most important reason on earth to get these bonds. The richest family on earth holding over 500 trillion dollars gets them, yes the Rothschilds.

    Do a search on youtube for this title “Evelyn De Rothschild Warning Masses – Too Late (Holding Bonds, Oil, Gold)” and you will see a video from CNBC the most trusted name in news showing Lord Rothschild saying during an interview with Maria Bartiromo that he personally invests only in Tax Free muni bonds.

    Also do a search for “the money masters” and you will see just how rich Lord Rothschild is and that the Federal reserve itself buys bonds as a hedge before it lends money to guarentee that the USA Govt has to tax the people to pay them back.

    You do not buy these strictly because your in a upper tax bracket. You should buy these to offset your core. Your core is bills that you have from when your younger till older that never go away such as rent and electic.

    Forget that nonsense about investing for growth and wait till your retired to do fixed income. I would atleast put 20% in fixed income Triple tax free muni bonds at any time and at least 5000 a year or if your richer 20% of your portfolio untill such time you have your core bills taken care of. This way you take the interest payment that is semi yearly and save it for just one year. Now you divide by 12 and have a monthly tax free income.

    Example. 15,000 dollars put in Tax free muni bond paying 8% coupon. You get 1200 a year. Wait to get both 600 dollar twice annual payments totalling 1200 then divide it by twelve. Its like you have a check for 100$ a month for life because you simply reivest the 15000 each year at the 8% You simply buy more bonds each year to hedge against the inflation as your still putting atleast 5,000 dollars every year at minimum no matter what.

    Sure you will lose money from interest rate but that 100$ today is money in your pocket backed by the govt that will pay your cellphone bill.

    Then you keep the cycle going untill you have enough to pay all your core bills on interest income alone. Core bills are like your rent, electric, gas, water, phone, food. Not your cable, magazine subscribe, fancy restaurant, and credit cards, or other bills you dont need or want to survive on. (you eventually do a 2nd investment core for those fun things)

    So the plan is to have tax free income from muni bonds paying 8% and having that to cover your lifes core bill, the bills that will never leave you ever like rent. Even when you own your home free and clear you pay rent. Dont believe it, take your yearly property tax and divide it by 12 and see how fast you pay estimate 425$ a month to live in your home you own, so just get a tax free muni bond to cancel out the 425 and only then are you freed from the financial banking slavery system, and good luck 🙂

    The above is not investment advice but rather an a example of why to invest in tax free muni bonds that are guarenteed income backed by the municipalities ability to tax its people.

  16. David S. says:

    Dear Mr. Redshield,
    Your example is completely flawed due to the fact that you are using an 8% return on muni-bonds. That rate of return simply does not exist nor will it ever. In fact, most muni-bonds throughout the country are so conservative that the YTM averages less than half of your 8%, at a measley 2 to 3%. That’s God-awful and not very appetizing at all!

  17. Mills Tuttle says:

    Have approximately $80,000 to invest. I need the safest and the greatest income return I can get. All suggestions welcomed!

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