How to Invest in Municipal Bonds
Sub-prime worries and bond market freezes should be enough to scare any income investor away from the markets in favor of a safer alternative. The municipal bond market has always been a safe haven for investment dollars, but understanding the investment offers is not easy.
The best part of municipals is that buying directly can mean helping your own community. Whether it is building a new city pool, more schools, or a mega stadium, municipal bond dollars go right back into your own community. They help hire local workers and give large contracts to local firms. All in all, municipal bonds are a great way to better your community and your retirement portfolio at the same time.
Municipal bonds also benefit from their tax-free status, preventing Uncle Sam from stealing the bulk of your interest earnings. If the municipal bond is for a project within the same state, you’re also likely to be state tax-free. It’s a win-win situation all around.
Without the tax-free benefit, returns from municipal bonds would be downright horrible. The average A-rated bond generally yields around 4% per year, which by today’s standards seems like a boring investment. Couple this with a tax free status, and its return is equal to that of a taxable account earning about 5.6% a year. Very few investment vehicles will provide you with a 5.6% return without risk. Unlike corporate executives, it is unlikely that your city government will get up and walk on your bond.
Interest rate cuts
As interest rates are cut by the Federal Reserve board, tax-free municipals become more attractive as Treasuries lose their edge. Historically, a municipal bond is just about as safe as a treasury; only 1 in 400 has failed, and even then, most municipal bonds are backed by insurance corporations. Warren Buffett has been in the spotlight recently for insuring billion in municipal debt.
Your money is safe with municipals; however, you are exposed to the downside risk.
Bonds can decrease in value, but municipals are generally much less volatile than corporate debt. As Wall Street starts to worry about the future of the economy, municipals should go up in value from an influx of cash.
Buying can be difficult
Getting into municipals can be the difficult part. Compared to the stock market, municipals look like an organized disaster. There is no central trading post for municipal debt. Buying municipal bonds directly is a great option, as you will know everything about the particular bond, such as maturity date, coupon, and when it may be redeemed or called. There is significant benefit to buying directly, and thus, the added work is usually worth the effort. Buying municipal bonds directly also avoids paying yearly management fees associated with funds.
However, most importantly, you can fund the projects you support. Want to see a new sewer system on your side of town? If the system is in the plans, chances are you can buy a bond to help fund it. Municipal funds are a great way to encourage development in your own area and profit at the same time. If you are opposed to the new jail on the other side of town, do not fund it. Municipals let you put your money where your mouth is.
You can usually buy municipals directly from large brokerage firms. It would help to go to established brokers in your own area who might be more familiar with your locale. Commissions are done entirely different than that of stock trades; your commission fees are added as a percentage of the investment. Transaction fees normally cost from .25% to 3% for most municipal funds, which is minimal dispersed through the life of the bond.
General obligations bonds are the best because they are backed by the taxation of your locality and benefit from higher volume. You can usually invest even safer by putting your money in insurance backed investments, which are a near 100% risk-free investment.
Different municipal funds
If you would prefer someone else to conduct the dirty work, there are plenty of mutual funds dedicated to municipal bonds. Be wary though – municipal funds generate low yields so any management fee is likely to put a dent in your returns. Better management might be the key to getting a better return, and Vanguard and Fidelity typically have strong municipal bond funds.
Quality municipal bond funds are not hard to find, and the market for municipal funds is dominated by just a few major players. Stick with the best brand names with the lowest fees, as all municipal funds are likely to have similar returns. Bond funds are a great way to get your feet wet without the high minimums of direct purchases and the added work of dealing with a brokerage firm.
Another option is the closed-end bond fund, which trades like an ETF. Most closed-end funds sell for a discount of their actual value, making them a great value for retirees who want long term stability. The discount gives an immediate return on capital.