A million and a half combinations of issuer, coupon rate, and maturity
In the 2002 Census of Governments, there were 19,429 municipal governments, 16,504 towns, 3,034 counties, 13,506 school districts, 35,052 special districts, the 50 states, plus Puerto Rico, Guam, other muni-issuing territories and Indian tribes. 60,000 local governments are said to have bonds outstanding in the hands of the public.
An issuer generally has more than one issue outstanding. And each issue is like many-in-one, made up of “maturities,” blocks of bonds that come due from now to the year 2040 and longer. It takes 1.5 million distinctly different 9-digit CUSIP numbers (stands for Committee on Uniform Securities Identification Procedures) to represent all the existing combinations of issuer, coupon rate, and maturity that make up the $2.85 trillion of munis that are outstanding. All those choices provide great flexibility in matching bonds to the myriad of human needs.
From what you say about you, a veteran municipal bond man or woman will find out some things you didn’t say. How likely you are to jump in and out of your bonds? Do you really need the income from your bonds now? How much is the peace and quiet of triple-A worth to you in cold cash? Is this money you are going to have to put your hands on in a pinch. Your answers will take 1.5 million possible combinations of issuer, coupon, and maturity and boil them down to three basic decisions:
Whether to go for triple-A, or relax on rating and go for yield?
Whether to go for the full good of your investment here and now and every time you clip a coupon, or to defer return to maturity?
Whether to go for the liquidity of short term bonds or the higher return of long term bond
NARROWING CHOICE TO
BONDS THAT FIT
For practice at matching bonds to your own needs, I invite you to have some fun with the MuniProfiler. The MuniProfiler is my thinking, modeled into a computer – to do what I do when I listen to a customer, and then search the bond market for the combination of issuer, bond rating, coupon rate, and maturity that fills the bill. Only The MuniProfiler does it faster and in writing. With the investor’s answer to a questionnaire with the same questions I would ask -- age, taxable income, investment objectives, appetite for risk, timetable for putting their hands on their money again as its search criteria – the MuniProfiler scans hundreds of offerings in its memory, weighs ratings, balances yield against maturity, and all that, and hunts for the best buys that fit.
In nanoseconds, up pops a printable model portfolio, averaged as to interest rate, maturity, annual income, and how much a taxable investment would have to return in any of the 50 states and Puerto Rico to match it. For fun, change your answers, and a different portfolio comes up reflecting the new criteria. The bonds in the MuniProfiler’s memory are not current offerings and their prices reflect the bond market in September 2010. But seeing your own analysis of what you want from your money played back to you in a hypothetic bond recommendation is a dry run for picking and choosing municipal bonds on your own one day.
INDIVIDUAL BONDS VS. BOND FUNDS
Lesson 11:
Decisions Decisions!
High Coupon v. Low.
Premium v. Discount. Long v. Short.
Bonds v. Funds
Bonds With High Coupon Rates. Let’s say you need income to live on now. Go for bonds with full coupon rates. If you have to pay a premium, pay it. The premium is not money lost. Instead of getting it back at maturity, you get it back, right along, bit by bit, in the interest being spun off by the coupon, part of which is return of your own money, the rest of which is new tax-free interest being earned.
“Zeroes,” For Deferred Interest To Build Tax-Free Growth. Traditional municipal bonds pay out interest right along, usually every six months. But zero coupon municipal bonds pay out nothing until maturity…zero. So why would anyone buy a zero? Because zeroes sell at deep discounts below face value. Your original investment “accretes” every six months as though earning interest. But instead of spinning off the interest in the form of current income, the accretion is added to the pot and earns more interest, building and rebuilding on itself, right up to the day of maturity. For every $25,000 or so you put in now, depending on maturity, you can wind up with $50,000 down the road, when children are ready for college (or you are ready for retirement). The difference between the initial offering price of, say, $25,000 and face value of $50,000 at maturity is tax free, federally tax free and usually free of local income taxes in the state where issued.
When Do You Want To Get Your Money Back? In other words, choosing maturity. If you know you will need your capital in the foreseeable future, you should invest in bonds which mature accordingly. If you have no timetable for the reuse of your money, but just might need it sometime in the future, stagger your maturities. Build a “ladder.” Ladder is simply the name for a portfolio that is scheduled to return your investment at regular intervals. One thing you should know. Bond calls before maturity can alter the annual return of principal from maturing bonds that you had carefully planned on. Maybe, just for the purposes of laddering, you should think of, say, a 20-year bond with a 10-year call as a 10-year, a 10-year bond with a 5-year call as a 5-year bonds, and so forth.
The Year 2040, Nothing To Fear. If you have no intention in your lifetime of spending the money you’re putting into bonds, don’t shy away from long term bonds. So what if you don’t think you’ll be here in the Year 2040? What difference whether you leave dollar bills in your estate or bonds that are worth dollar bills? The only virtue in buying maturities that coincide with your life expectancy is the sense of symmetry it will give your mourners that both you and your bonds were redeemed on the same day.
Short Bonds – If You Must You Must. When the yield curve has its normal uphill slope, short maturity bonds don’t pay as much as longer maturity bonds. Even so, if you know you are going to need your money in one or two years, buy short bonds that mature in one or two years. Short bonds fluctuate less in resale value, because the closer a bond is to its maturity, the closer its market value will be to the price it will soon have to pay at maturity: face value, par, 100! So financial institutions and individuals who are interested in municipal bonds for temporary investment, or who are hedging the bet on interest rates, buy short maturity bonds and don’t subject their liquid assets to the vagaries of the market.
Are You Subject To The AMT? The interest from certain municipal bonds, deemed by law “private activity,” may be subject to a tax calculation (see table) known as the Alternative Minimum Tax. AMT bonds are clearly identified as subject to AMT. And investors with enough tax write-offs and preferential income to trigger an AMT liability certainly should avoid them. But if you don’t have an AMT liability – and your vulnerability to the AMT is not aggravated by exemptions for a large number of children or deductions for high state and local income taxes, incentive stock options and the like – AMT bonds could be a windfall. That is because AMT bonds pay an extra 15 to 20 basis points to compensate for their taxability in the hands of those who do have an AMT problem. Whether to reach for the extra yield is something to bring up with your tax advisor.
