Listen as we discuss why municipal bonds work for some investors; the best type of investment account for municipal bonds; and the interest and tax impact.
Hi this is Michael Carlin president of Henry Antoine wealth management with your manager of funds podcast. Today we’re going to talk about how to buy municipal bonds. Why munis? Great question. Glad you asked. And this is a question that we got from listeners. Municipal bonds are our super important for. Lots of different portfolio types. Now no one investment is perfect for anyone so let’s just make sure we’re really clear on that. Municipal bonds may or may not be ideal for you but they work for a lot of people.
Particularly in really needs to be in a taxable account an account that as it earns interest you have to pay tax on it every year. Municipal bonds not the kind of thing that you put an end of retirement account of any kind because you don’t pay tax on those on an annual basis. So if you have an investment account that’s taxable then a municipal one may be the perfect place for you. So let me be sure to state that Municipal bonds aren’t for everyone. As I’ve already said I’ll say it again it is not a blanket recommendation but they are key and critical for a lot of portfolios.
So we want to make sure that when you’re buying municipal bonds you got to do it right. Lots of people who buy municipal bonds understand the fact that second to a United States Treasury many consider municipal bonds second in quality just the United States Treasury which is considered by many to be the safest security around. But what is a municipal bond is a state backed bond and there’s lots of different state backed projects that states raise money for and they do so by issuing a municipal bond in the nice benefit is the states don’t have to pay a lot of interest.
As a benefit to them. There is no federal tax due on the interest that is paid out by the municipal bonds. When you when you sum it all up if you’re an Arizona resident for example and you buy an Arizona municipal bond it’s for some Arizona based project. And if there’s interest that comes out you don’t pay federal tax on the interest and you don’t pay state tax on the interest if you’re an Arizona resident but if you buy a municipal bond from anywhere else in the United States. And you’re not a resident that interest you will pay your state tax on.
So now that we’ve established that we’ve established the quality we know this a tax free nature to the interest that comes out which is a key and critical component. So bonds are also very liquid which means that any event you need to sell them there’s often a pretty good market to sell them in. Which is great. A municipal bond those strike a price daily. You have a pretty good sense for what you’re going to get seeing it in and you can get out of them fairly quickly fairly easily. Lots of people look at it like Well that sounds like a panacea.
This sounds great. I should have some of those. Probably if you’re worried about the market going down probably you should own a municipal bond if you’re in one of the higher tax brackets too but buying a muni isn’t easy. It’s actually really difficult. So that’s where we have to have a how to. We don’t want you buying him Miss Obama without listening to this how to first municipal bonds. Don’t trade on an exchange like. You can’t turn the TV on and then you see the ticker moving on the bottom of the screen.
Those are stocks and you’re seeing fresh trades people buying and selling and that’s the price there that there is no stock exchange for bonds. It’s not how it works. Bonds are sold. Person to person party to party which makes it a little bit like the Wild West. You kind of get a sense for what the prices but it’s not perfect. You need to know that going into it that means bond environment has also changed a lot over the past number of years. Interest rates are at or near you know 50 year lows depends upon when you’re listening to this.
But interest rates are a lot lower than they’ve been over the past number of decades. Most people that insure municipal bonds. Are out of business.
People who own small little municipal bond pieces and you’d be surprised when I’ll say what a small municipal bond pieces. It’s hard. It’s getting harder and harder to trade those. Because liquidity is down. The limited available supply is down. Oh my goodness. Go on one hand he’s safe and secure and I liked all of that stuff that you were saying. Mr. Bond sounds great. But now there’s no exchange I don’t know you know how am I going to get it and if most of the bond insurers are out of business is my money even safe.
And now it’s small position size as well what’s that. Small position size in a municipal bond is anything. Anything even less than one hundred thousand dollars is a small municipal bond position size which has I’m sure many listeners saying can’t be it’s true municipal bond markets highly institutional veil. There are places that will allow you to buy smaller bond lots but be really careful before you buy. We’ll tell you how to buy just to make sure if you’re gonna buy in smaller lots. How to attempt it to try to do it without paying too much.
So with that let’s go to the next. The next component of this is that. Municipal bond buying is a lot harder than it used to be. If I look back at 2006 December 30 1st 2006 just about 70 percent of all municipal bonds were triple-A rated triple-A rated. They were the highest quality that exists. Great. Fast forward to December 30 first 2016. Ten years later 17 percent. Of municipal bonds are triple-A rated. Wow. Used to be again the vast majority of bonds that were out there had this great quality to them.
Well without many of those bond insurers a lot of those triple-A ratings went away.
And so with that increased risk comes an increased sense of research that you must do to make sure you understand your municipal bond. I mentioned that the state project. Well what’s the state project. Is it a highway. Is it A. New football field. Is it a new school. Is it a for public works water energy utilities. There’s nearly an infinite amount. There’s about 500000 different bond types. Municipal Bond types. You don’t know them all. And in it. To give you a sense in a scope 500000 Muniz.
There are only about 3000. Listed stocks. Five hundred thousand units. It’s a different to different jungle to different a different ball field in it’s a different kind of investment class or buying this kind of quality isn’t going to be easy. Something we can do though. You need to be keenly aware of that lot size. We talked about buying big if you buy. A municipal bond somewhere between twenty five thousand one hundred thousand that’s the amount that you invest to buy one bond. If you look at the information that I have.
The average markup that you were paying in 2004 was one point two percent. The average markup today on the same twenty five thousand two hundred thousand dollar bond lot sizes one point six percent. Is probably saying is that a lot. One point six percent is a huge amount. With the municipal bond you’re really depending upon how far out or how long or how long the bond matures. It’s going to determine what the rate of return is.
In today’s markets if you’re earning a 4 percent or a little bit more rate of return you’re going out a little bit of a ways in giving up one point six percent to just fees in acquiring the bond alone. That’s a big chunk. You got to be careful of that. Conversely if you look at the data for bond trades that are done for every one bond you buy if you buy it in a million dollar block it used to be point one percent cost 2000 for. 2016 The cost is point three percent.
Just to review one point six percent cost buying one bond between twenty five thousand one hundred thousand point three percent today and a bond over a million. Like I said buying in small lots can be difficult. You got to have the information behind you. There’s a Web site called Emma e MDMA. One of the beautiful things about municipal bonds is that they can be transparent. Emma will tell you. When you enter into a particular kind of bond type what the historical trades were. You’ll know. You’ll understand what the markup is.
It’s. Key and critical. You can’t get that kind of information on stocks if that information exists on bonds. Go to the Web site it’ll tell you a lot about markups. So there’s also a huge change again mention a little bit about credit quality but the number of upgrades and downgrades. Is staggering. In 2015 alone there was over half a billion dollars of municipal bond downgrades that year. Meaning there were concerns about the quality of the issuers.
Of these municipal bonds. So when you’re buying a bond you’re going to want to understand whether or not that meaningful Bond isn’t on credit watch. Is there something that is being looked at either credit a credit watch positive like there’s an improvement or credit. Credit Watch Negative like there’s something to be concerned about here. Absolutely look at that component. Because know that it’s just because something’s rated triple-A. I’m sorry or even double A which should be more common or single A which would be still yet more common if you see a bond like that.
I would want to know not just what its rating is today but is it credit watch positive or negative. What have been the changes in the underlying credit of that issuer. Gotta know. If you look at the new issuance of municipal bonds it’s. Unbelievable. There haven’t been that many new municipal bonds issued and you certainly when you laid out any compared to things like the U.S. Treasury. The U.S. Treasury which you know we’re now past 21 trillion dollars of. U.S. Treasury bills and as of 2016 worried about call it four trillion dollars of munis.
And we have by comparison about nine and a half trillion dollars of corporate bonds. So the municipal bond markets are a lot smaller than the corporate bond market. And it’s a lot smaller than the Treasury market. And we’re not seeing a whole bunch of new municipal bond issues being. Brought to the market every year which is slowly shrinking the supply the supply isn’t all that great as the supply gets tighter the prices go up which is a part of the reason why you’re paying more in bond fees. It’s incredibly competitive.
In its difficult. Environment that we don’t see getting a heck of a lot better so be very cognizant. Of it means more bond total supply. Because we don’t want you paying more for bond than you have to. So the municipal bond we talked about it’s a large market it’s an inefficient market. And then you’ll see things like Detroit or Puerto Rico when those things happen. It’s if you own a Detroit or Puerto Rican municipal bond you don’t. That’s those are bad days. Those are bad days. The value of those bonds go down and it creates concern and cause.
But what you don’t may what you may not have understood is that you might not have known is that. Lots of municipal bonds across the board just because Detroit went down all go down with it. It creates buying opportunities. So we would look at. Significant situations that happen. In maybe you can use that as an opportunity to buy favorably. I’m not saying bright Detroit or Puerto Rico but. You’ll see a lot of mutual bonds getting thrown out. With some of those other issues. We’re also going to want you to pay attention to things like which states have significantly underfunded pensions.
Meaning which states are going to be in financial trouble. Some of those states tend to be the states that have the most amount of municipal bonds. So be careful about those states. You don’t get. Dragged into a state that’s going to end up having some financial difficulties we would obviously if we could have around the clock hopefully it’d be things like Detroit. And like Puerto Rico that you want to avoid moving forward. One of the things you need to know when you’re buying a municipal bond is that the longer the bond is the longer it takes before it matures typically tends to pay you more the shorter a bond is i.e. meaning the quicker it matures usually it’ll pay you less.
So as I take a look at at what this what this and they call a kind of a yield curve is in that it’s. Low to high. You’re expecting to earn somewhere again in today’s market maybe somewhere around two point. Down enough to point to two point three percent somewhere in that range for a four year municipal bond and you’re hoping that if it’s a 15 year bond you’re hoping to get somewhere. I don’t know in three and a half to 4 percent range tax free. Which is good. Because if you’re earning 2 percent tax free or 4 percent tax free and if you’re in one of the higher tax brackets it’s really like earning almost 4 percent.
And it’s really like earning almost seven percent. On those two different bond issues. There’s a real rationale and a real level of excitement people have with Muni because it means because the total return can be great relative to an after tax return. There are a few different ways you can construct your municipal bond portfolio. You can do it in a concentrated fashion. Meaning you can just focus on one particular part of year you can do a laddered which means you have bonds that come due every year over time you can do a barbell some short some long some short.
Here’s the thing. Depending upon the interest rate environment that were in. Those strategies are going to differ but you’re going to want to understand their interest environment that we’re in now and as of today is we recording it’s pretty flat. So you’re going to want to really be careful and pay attention to the yield curve shape and buy your bonds in the maturities accordingly. We want you to best position your meanest municipal bond portfolio as to how you’re going to do it. You’re going to want to understand the changes in the muni market.
You’ve done that now. You know that bonds aren’t as high quality as they used to be. You know that the insurers aren’t where they used to be. You know that weren’t a flat yield curve environment. So. You’ve got to be careful when you’re picking your maturities. You’ve got to try to buy in big lots. One of the ways that you may want to be buying your bonds is you may want to look at a mutual fund that can do all of this stuff for you. A good municipal bond mutual fund is something that’s easy enough to research.
Straightforward and ill allow you the opportunity to have an institution buy the bonds for you rather than you doing it yourself because again buying in small lots is difficult and can be dangerous. So I’d encourage everyone to just take a look at the benefits of an active management mutual fund approach before you go ahead and dive in and buy your big bond portfolio. So. With that that is our how to buy municipal bond piece by your friend Michael Carlin president of Henry Norton Wealth Management. Thanks so much. Take care and have a great day.
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