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Thinking about supplemental sources of cash flow, retiring, changing jobs or selling your business? A predictable cash flow from a portfolio of high-quality individual tax-exempt municipal bonds can meet your needs. When you purchase individual muni bonds on a regular basis, you are creating a system with the reasonable expectation that it will get you to a better place in your life. Scott Adams, in his new book How to Fail at Everything and Still Win Big, explains that a system is usually at the foundation of achieving success, as opposed to setting a goal in the hopes that at some time in the future you might achieve it: “A system is something you do on a regular basis that increases your odds of happiness in the long run. If you do it every day, it’s a system. If you’re waiting to achieve it someday in the future, it’s a goal.”1
Investing in high quality municipal bonds paying a predictable cash flow and returning your principal at the end of the investment is a well-trodden system for lifetime economic success. In this article we discuss some key issues in purchasing municipal bonds to help you make wise choices for your investing system.
Key Features of a Municipal Bond
Bonds are knowable because they share a basic structure. The key features of a bond are ratings, coupon, issuer, maturity date, yield, and call date. Some bonds are insured. Here are some bond basics that will help you understand the basic structure of a bond.
Packaged Bonds. Individual muni bonds may be packaged into bond mutual funds, exchange-traded funds (ETFs), closed-end funds and unit investment trusts. When individual bonds are packaged, they lose a key feature of individual bonds – a due date. That is why we recommend purchasing individual muni bonds. With high quality individual bonds you can plan on getting your money back when the bonds come due. You do not know what will be returned to you in a packaged investment, and you will be charged ongoing fees. You will not know what is inside the package unless you take the time to look and can evaluate the package. If you did look you might not be happy with the package and may decide to buy your own individual bonds.
Ratings. Ratings are supplied by Moody’s, Standard & Poor’s (S&P), Fitch Ratings and occasionally by Kroll Bond Ratings, the new kid on the block. The ratings are a shorthand way of summing up the financial strength of a town, county or state. When you consider a bond, always ask about the specific sources of revenue that are backing the bonds. If you are offered a new bond issue, ask to see the Preliminary Offering Statement (POS) and read the section entitled ‘security.’ That will tell you how the issuer plans to repay the bondholders. If the description makes your eyes glaze over, then pass on the opportunity.
Coupon. Troy, Michigan, recently issued general obligation bonds rated triple-A by Standard and Poor’s, its highest rating. These bonds have a 4.125% coupon. That means that for the duration of the life of these bonds, interest payments will be fixed at 4.125%.
Due Date. The Troy bonds come due on November 1, 2028. Maturity or due date is the specific date when the issuer promises to repay the face amount of the bond.
Call Date. Most bonds are originally issued with a call in 10 years, though some, like the Troy, Michigan bond has only call protection for eight years. A fixed call is a specified date when the issuer can but is not required to redeem the bonds. After the first call date the bond continues to be callable according to a schedule that is generally a call on the anniversary date. General obligation bonds tend to have fixed calls. Some bonds may also have other kinds of calls. Read our book BONDS:The Unbeaten Path to Secure Investment Growth for further explanation.
Yield. All bonds have a yield-to-maturity which is the return assuming that the bond will stay outstanding until its due date. All bonds that are callable have a yield-to-call, which is the return assuming that the bond is called on its first call date.
Research. You can verify information about an outstanding bond by going to EMMA, the website of the Municipal Securities Rulemaking Board (MSRB). This site brings needed transparency to the municipal bond market. It contains offering statements, material events describing actions affecting bonds as well as trade activity.
If you take the time to understand bonds, you can purchase your own high-quality individual bonds. A good rule of thumb is to see if Mr. Market prices similarly rated bonds the same. If the market pricing is significantly different, the bond you are considering may not be a bargain, but rather an indication of an unknown or unseen risk.
1. Scott Adams. How to Fail at Almost Everything and Still Win Big, New York: Portfolio/Penguin, 2013, p. 33.
