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Course Introduction

DO YOU BELONG IN MUNICIPAL BONDS? IF “BELONG” IS COMING ON TOO STRONG, REST ASSURED THE PURPOSE OF THIS COURSE IN INVESTING IN MUNIS IS TO GIVE YOU THE INFORMATION TO DECIDE FOR YOURSELF, IF TAX-FREE MUNICIPAL BONDS ARE FOR YOU IN YOUR PARTICULAR SITUATION AND PERSONAL INCOME TAX BRACKET.

IF YOU COME TO A HIGHLIGHTED WORD THAT COULD USE MORE EXPLAINING, ROLL YOUR CURSOR OVER IT, CLICK, AND BRING UP ANSWERS TO QUESTIONS YOU MAY NOT EVEN HAVE THOUGHT TO ASK. HERE’S EVERYTHING WE COULD PUT IN WRITING OR ON DISPLAY WITHOUT KNOWING MORE ABOUT YOU. YOU’RE IN FOR AN EDUCATION.

A municipal bond is evidence that a state, county, city, other locality, or agency of the state needed money and borrowed it to dig roads, build schools, pave runways, put up hospitals, move commuters, bore tunnels, bridge rivers, and otherwise provide for the physical underpinnings for our quality of life.  The bond is the municipality’s contract with its lenders to repay its debt on a definite date in the future, with a fixed rate of interest right along.  There are $2.7 trillion ($2,700,000,000,000) of these IOUs outstanding, and almost three-quarters of them are owned by individual investors, either directly or through mutual funds and trusts.

Besides raising the money for the hometown sewer system, other reasons may explain why individual investors, people in upper income tax brackets are the mainstay of today’s municipal bond market: 1) the heady appeal of tax-free interest, and 2) the reputation of our American cities and towns have for paying their interest every six months on the dot and full face value at maturity - if you stay the course and hold to maturity.

Unless issued and described as a taxable municipal bond, or quoted to you as subject to the Alternative Minimum Tax (AMT), municipal bond interest is free of regular federal income tax.  Most states also exempt their own bonds in the hands of their own taxpayers from state and local income taxes (their constitutional right to do so, while taxing out-of-state issues was recently questioned and upheld by the Supreme Court).

The words “safe,”  ”safety,”  ”guaranteed,”  only address creditworthiness, the assurance of receiving your interest right along and principal back at the end.  If you sell before maturity, you may make money, you may lose money.  It all depends whether interest rates are higher or lower than when you bought your bond, and on the fortunes of your particular issuer. Fluctuating resale values are simply a fact of life.  Bonds go up. Bonds go down.  But the history of municipal bonds of all types for paying their debts speaks for itself.

NEXT: Lesson 1 - Suitability

Basic Arithmetic Tells You When You Belong In Municipal Bonds

Any extra income that doesn’t add to one’s taxable income bracket increases in value by the amount of the taxes saved. Say you earn 5% taxable and file a joint return this year on $250,000 in New York City.  After the IRS, the Governor, and the Mayor take their cut, you wind up with 3%.  Not a very lordly return when the bond of any municipality in NYS paying 5% lets you keep the 5%. The demand for income that lets an investors keep 100 cents on the next dollar earned without bumping them into higher tax brackets has ramifications for municipal issuers. Our cities and towns are able to borrow for public necessities in the tax free bond market at below taxable market rates.  Although that means their munis pay less nominally than comparable taxables, upper bracket muni buyers aim to come out significantly ahead in taxes saved than in interest forgone.

That’s where this business of belonging or not belonging in municipal bonds comes in.  Individuals in low to no tax brackets are usually better off in taxables – and paying any applicable tax.  Belonging in munis, i.e. suitability, is a function of one’s own personal income tax bracket.  Step One in deciding if municipal bonds are for you would be bringing up the Taxable Equivalent Yield Table for the state where you pay tax and running your finger across the row with your income and tax bracket and down the column with the tax-free yield under consideration. At the intersection is the interest rate the taxable investment would have to pay you before taxes to net the same take-home interest the municipal bond pays your tax free.

Click on your state, and download the Taxable Equivalent Yield Table:
AL | AK | AZ | AR | CA | CO | CT | DE | DC | FL | GA | HI | ID | IL | IN | IA | KS | KY | LA | ME | MD | MA | MI | MN | MS | MO | MT | NE | NV | NH | NJ | NM | NY (outside NYC) | NYC | NC | ND | OH | OK | OR | PA | PR | RI | SC | SD | TN | TX | UT | VT | VA | WA | WV | WI | WY |

Do you belong in municipal bonds?  There is no iron rule for determining how much more you should take home from a tax-free municipal bond than you can keep after taxes from a taxable alternative.  Let the bond industry’s Rosetta Stone, the Taxable Equivalent Yield Table (below), tell you and do the talking.

Of course, there is a more conservative table for determining suitability: the What’s-Actually-Left-In-Your-Pocket-After-Taxes Table.

Take a husband and wife who filed a joint return in 2009 on $225,000 after deductions and adjustments. Find their income in Column A and, reading across, their federal income tax bracket in Column B. Whereas, in their 33% federal tax bracket, they would turn over to the federal tax collector 33 cents of the next $1 of taxable income they earn, if they earned 4.00% from a tax free municipal bond, they would keep the 4% (Column C). They would keep only 3.02% from a 4.5% federally taxable United States government obligation (Column D), 3.35% from a 5% corporate bond (Column E), which doesn’t take into account the consequences of any state and local income taxes. And they would keep 3.85% from a corporate ETF paying 5.75%, also not taking into account state or any local income taxes (F). A taxable investment would have to pay this couple 5.97% (G) to match the 4% muni. On the basis of arithmetic alone, they belong in Municipal Bonds. Do you? Consider your “or else.” Then, you decide.

Caveat Number One. It’s not how much you earn that counts.  It’s how much you keep – after taxes and inflation.  Munis eliminate taxation from the equation.  But inflation comes right off the top, leaving you with a Real Rate of Return which is the take-home pay you pocket after inflation.

As we’ve said, inflation is the scourge of any fixed-income investment.  Using the full height of the graph (black+shaded) to represent the Bond Buyer 20-Bond Index, an average of 20 representative long term general obligation bonds, and the Consumer Price Index (CPI) to represent inflation (black), the real rate of return after inflation (BBI-CPI = RRR) ranged from 3.76 percent in 2001…to a low of 0.78 percent in 2005…to a high of 5.24 percent in 2008. when the CPI was 0 percent and the full yield of the muni was all yours to keep. In 2009, with the BBI-20 at 4.61 percent for the year and the CPI at 2.7 percent, the Real Rate of Return was 1.91 percent.

Caveat Number Two. In determining how much a dollar of income that’s tax free is worth in your bracket, compared to your takehome from a taxable investment, just make sure you compare apples to apples, munis to an alternative taxable investment of comparable maturity and quality. It’s loading the deck in favor of the muni to get into the routine of comparing them to, say, Treasuries or bank CDs, when CDs are federally insured. And there’s a penalty but no market risk for redeeming a CD before it matures.  If you have to sell a bond prematurely, you may make money or lose money, generally depending whether interest rates are higher or lower than when you originally bought your bond.

NEXT: Lesson 2 - The Tax-Free-To-Taxable Yield Ratio

It’s The Closest Thing We Have To A Bell That Rings.

There is no question that the spread between tax-free municipal bonds and the taxable alternatives narrows and widens with market conditions, making munis a relatively better buy at some times than at other times.  The closest thing we have to a “buy” signal is the Tax-Free-To-Taxable Yield Ratio.  To calculate the ratio just divide the yield of the tax exempt you are considering by the yield of any taxable alternative you want to compare it to.  Treasuries are usually the standard to which the municipal is compared.

At this moment of writing (January 27, 2010), with Aaa-rated 10-year munis at 3.00% and 10-year U.S. Treasuries at 3.63%, the Tax-Free-To-Taxable Yield Ratio is 82.6%.  You could say that in a 17.4% federal income tax bracket, if such a bracket existed, 10-year munis and Treasuries would be a “wash” in economic value.  In higher brackets, munis begin to get interesting. And in the top 35% federal tax bracket (for marrieds and singles paying tax on $373,650), downright interesting.

The ratio measures the spread between tax-exempt munis and your choice of taxable alternative and thus the relative attractiveness of the muni compared to your “or else” right now.  The ratio, however, is of little predictive value as to where interest rates for both munis and taxables in general are headed. That’s the trouble with the future. It always lies ahead.

From time to time we compare the tax-free yields of municipal bonds to the after tax yield of bank CDs.  Let us be quick to say that bank CDs are federally insured.  And there may be a penalty, but no market risk for early redemption.  If you have to sell a bond prematurely, you may make money, you may lose money.  It generally depends where interest rates are at the time you sell compared to when you bought your bonds, and on the fortunes of the issuer of your particular bond.

NEXT: Lesson 3 - Fluctuation

“If I sell prematurely, how much will I lose?”

The words “safe,” safety,” “guaranteed,” as used in bonds apply to creditworthiness, the assuredness of receiving your interest right along and principal back at the end.  That’s the beauty of the fixed income investment.  Your return is so knowable up front, except…how much you would receive if you had to sell in the open market at the going rate before maturity.  Let it be said loud and clear that the resale value of your bonds before maturity can rise or fall with economic conditions, changes in interest rates, or with the fortunes of your particular issuer.  It says something about the conservatism of fixed income investors that few ever ask, “If I have to sell, how much can I make?”  It’s usually, “How much will I lose?”

For a worst case scenario of market volatility – worst in our experience — we have tracked the resale values of 20-year New York State general obligation 6s of 1990 from when they first came to market in June 1970 to maturity in June 1990 when they were redeemed at 100.  During a period marked by Nixon wage and price controls, stagflation, recession, the Great Inflation, the Volcker era of tight monetary policy, the highest interest rate in U.S. history, the Crash of 1987, bids ranged from 98 cents on the dollar the day the bonds were issued at 100 (two points being the normal spread at the time between bid and ask) to a high bid of 111 in 1972 and low of 64 in 1982. Cash-in value on June 1, 1990: face value of 100.

Anyone considering municipal bonds must accept market fluctuation – and possible loss in resale value before maturity – as facts of life.  But “yield to maturity” presumes that if you hold your bonds to maturity, get your interest right along and face value back at maturity, you will wind up with the yield to maturity you were promised.

NEXT: Lesson 4 - Timing

The Money Game People Love To Play

There is no escaping the fact of life: the price you pay for a bond today is going to engrave its yield to maturity on your books for however many years that bond has to run.  So one of the money games people love to play is waiting for interest rates to go up.  The wish being father of the thought, lenders always think interest rates are going up.  And they’re right.  Of course, interest rates are going up, then down, then up, up down, down up.  Speculating on interest rates is irresistible, because, at some point you’ll be right, if you play the waiting game long enough.  The worst thing that could happen is to be right the first time and be fooled by intimations of infallibility.  The advice of this expert: take any investment advice based on foretelling the future of interest rates, including ours, with a grain of salt.  If I say, “Wait!  I think interest rates are going up,” stuff wax in your ears and tie yourself to the mast. I may be right, but I have no way of knowing.

NEXT: Lesson 5 - Ladders and Barbells

Never all long.  Never all short.  Never all wrong.

Long versus short. Tough decision.  If you know you are going to need your money back in 2, 3, 4 years, buy bonds that mature in 2, 3, 4 years.  You can sell your longer bonds before maturity at going market rates.  But why subject your savings to the vagaries of the marketplace?  On the other hand if you have no particular timetable for the reuse of your capital, build a “ladder” of staggered maturities.  Re-investing the proceeds of maturing bonds keeps you abreast of any changes in interest rates, up or down, over the life of your portfolio.

If you are getting on in years, build a “Barbell Portfolio” of long maturities at one end of the portfolio for their relatively higher yield and short bonds at the other end of the barbell for their relative market stability.  Ladder the short maturities to come due over a reasonably comfortable span of, say, one to five or six years.  And at the long end of the barbell go for the highest yields you can lay your hands on, if it’s money you have no intention of touching in your lifetime.  After five or six years all your original short bonds will have been replaced at new going rates.  Meanwhile the long end of your barbell remains intact, earning the higher return you locked in when you began your Barbell Portfolio.  A good portfolio is diversified as to maturity as well as locality.  “Never all long.  Never all short.  Never all wrong.”

NEXT: Lesson 6 - More on Long Maturities

How to get the most out of a municipal bond without waiting until the year 2030.

   

One way is to buy municipal bonds maturing in 2030 — even if you don’t expect to be around by then.  This seeming paradox is explained by the fact that it is not a contest to outlive your bonds.  If you want your income now to live on, go for bonds with the highest coupon rates you can get your hands on.  And enjoy the superior current return being spun off by that high coupon rate during your lifetime.  And when your bonds come due, your principal will be returned to you, or to your heirs. (You’re going to leave an estate in some form.  What difference whether you leave them money or municipal bonds that are worth money?)

How long is long term to you? One year…ten…twenty?  For some people long term is one day loner than when they need their money back.  But if it’s money you haven’t touched in years and aren’t likely to touch, time is your partner in life and investing.  After the 85 years Lebenthals have been at this business of municipal bonds for the individual investor — through 5 wars, 14 recessions, 1 Depression, The Great Inflation, The Great Recession, and market after market – we have acquired a reverence for time. It heals. It gives the pendulum a chance to swing both ways. It smoothes out the lumps. It gives a run of tails a chance to come up heads. It turns the ups and downs of markets that feel like forever into just another day on the way to San Jose.

What’s 10, 20, 30 years to a professional who sees 10, 20, 30 year bonds mature every 15 days?

If you know you are going to need your money for a specific purpose on a specific date in the future, target the maturity date.  But if you can be open ended about maturity – and don’t need the interest income from your bonds to live on, consider what happens when, say, the tax free dividends of a mutual fund of tax exempts, instead of being paid out, are reinvested in additional fund shares that accumulate and build.  Compounding by itself is no guarantee of investment success and can be humbled by loss of market value in the thing compounding.  But it stands to reason that the more of that thing accumulated over time, the bigger the multiplier than will be working for you when you decide to sell.

Time is the stuff of compound interest.  It is the soul mate of investing, and the best friend the long term investor’s got.

NEXT: Lesson 7 - Ratings

Uh oh!  Only Single-A?  Something Must Be Wrong.