Author Topic: Tax Free Municipal Bonds  (Read 2692 times)

momcpa

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Tax Free Municipal Bonds
« on: June 12, 2016, 08:16:03 PM »
Our financial advisor has suggested putting some of our "excess" cash funds into Tax Free Municipal Bonds.  His point is that we don't have any debt and we have too much "emergency" cash sitting.  He feels we have ready access to plenty of other cash if we need money for a major house/car repair.  He mentioned getting approx 2.5% tax free interest. 

Please educate me with your opinions on the pros and cons of this type of investment.  Thanks.

GrOW

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Re: Tax Free Municipal Bonds
« Reply #1 on: June 12, 2016, 08:31:36 PM »
Two questions for you:

1) what are your marginal tax brackets? Federal and state.
2) are these individual bonds or a bond mutual fund?

momcpa

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Re: Tax Free Municipal Bonds
« Reply #2 on: June 12, 2016, 08:59:59 PM »
Federal  25%    State 3.75%

He mentioned both ways of investing as possibilities...individual and funds.  I've read about bonds trying to educate myself.  But not having used them as a investment vehicle yet, I was just looking for pros and cons.  I have a few questions already for him......

Always tax free?
Always State tax free?
If they are being managed in a fund, am I paying some of my savings to the manager?
Are my funds safe......bankruptcy of the municipality?
What time-frames are available/advisable?
Is "laddering" always a good way to set them up?

I feel I just know enough to be dangerous !!! So I want to be informed and comfortable.  I agree with him that we have excess cash just sitting as cash right now.

Thanks for any insight you might have.

Systems101

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Re: Tax Free Municipal Bonds
« Reply #3 on: June 12, 2016, 10:31:18 PM »
One question for you if you really are holding too much cash and don't have a target for using it, why would you put it in bonds?  It really makes sense to step back to your overall portfolio mix.  If you're currently underweight in bonds and need some, then great.  If you are already diversified and want to hold bonds, then why not just put the money into the same investment mix as the rest of your portfolio?  (That you will sleep better in a lower risk vehicle than stocks is fine - just make it a conscious decision about how to invest)

Specifically to bonds:

The "pro" here is you do get better yield than holding cash.  It's also nice to have some level of funds that dodge the federal tax bullet.

The "con" comes in a few forms.  The first is that bonds do not trade like stocks.  If you need to "get out early" the trading cost is not 1c/share or some such spread.  The spread can be $200 between what the price at which someone sold it to a dealer and the price at which you buy it.  The volumes (especially at the retail level) are just SO much lower than stocks that the market functions differently.  So expect to "take a haircut" if you really need the money early, especially if you bought in $5K increments (larger volumes are usually more efficient). 

As an example, go to EMMA (see below for the link) and look up 939783RM0.  This is "randomly" selected (happens to be the last bond that traded Friday). If you go look back at the trades in April, you will see a customer sold at 108.69 and another bought at 111.69.  This is quoted per $100 of bond, so $3 per $100 or $150 per $5000.  The broker/dealer got that for the risk of sitting on the bond for 4 days (not a bad return in that case).  Dealers can lose money, so they are compensated for the risk they take.  The June trade shows that risk - a customer sold $100K, a dealer bought it (the broker marked it up to capture a commission on the sale - you can see the 0.75/$100 markup between the two trades on June 9).  Only $60K sold on Friday, so the dealer is still sitting on $40K...

Another "con" is that municipal bonds are NOT risk free... they are also not all created equal.  In fact, municipal bonds can be completely confusing because there are SO many categories of municipal bonds it's crazy.  This is a good intro: http://morningstardirect.morningstar.com/clientcomm/municipal_bond_sectors.pdf

If you're going to invest in individual municipal bonds I highly recommend you learn how to read a bond prospectus, so you know how the municipality intends to pay back the bond.  You can find them on EMMA: http://emma.msrb.org/

I personally do have a few bonds in my portfolio, but much of that is heritage of 2008 where I bought when the market was a bloodbath.  I hold almost exclusively water/sewer bonds (with a sprinkle of school district debt).  About half have already matured (or really called), and most of the rest will do so over the next 2 years.

I would add to your questions for your advisor:

- At what point does he think the portfolio too concentrated to handle individual bonds vs a bond fund (what total $ level, assuming $5K investments)? [and bounce this against advice on diversifying any portfolio]
- What type of municipal bonds is he proposing (see below)?

My thoughts on your questions:

Always tax free?
Always State tax free?

There are bonds that range from not at all tax free (Build America Bonds, if you live out of state), to completely tax free (e.g. traditional municipal bond in state to the issuing bond).  If you buy individual bonds, you will need to get the info for each one.

Keep in mind that getting diversification may mean getting bonds from other states, so you lose some of the tax benefit. 

If they are being managed in a fund, am I paying some of my savings to the manager?

There will be an expense ratio of the fund, yes.   This is the same concept as the expenses on a stock mutual fund.

What is far more interesting to consider with bond funds vs individual bonds is some other items:
(1) Municipal Bonds are typically issued in multiples of $5K.  To get good diversification, you need a rather large bond portfolio if you do it with individual bonds.
(2) There are some big differences with interest rate changes.  With individual bonds, you always know what you will get back at maturity.  With a bond fund, they are rolling over bonds constantly, and the net asset value will change based on current interest rates.  So even if you dollar cost average back out of a bond fund, the dynamic can be very different than letting a ladder unwind.  It's different not necessarily better or worse.  See: http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2014/07/31/the-perils-of-bond-funds-in-a-rising-interest-rate-environment and http://awealthofcommonsense.com/2015/10/misconceptions-about-individual-bonds-vs-bond-funds/ for two opposite perspectives.

Are my funds safe......bankruptcy of the municipality?

...bankruptcy is a risk.  Some bonds are insured, some are not.  Some would argue the insurance is pretty worthless anyway, since at the peak of the 2008 crisis, most of the bond insurers looked like they would go bankrupt too.

Some are just downright risky: http://www.investmentnews.com/article/20160506/FREE/160509940/move-over-puerto-rico-illinois-new-jersey-and-other-states-face

Bonds are an investment like any other form of investment.  Each has risk.

Be aware! Different types of municipal bonds have different historical default rates, see here: http://www.naic.org/documents/committees_e_capad_investment_rbc_related_defaults.pdf ... this is why "Municipal Bond" is NOT specific enough.  The question is what type of bond?  The higher yields can mean higher risk - and in some cases that you are investing in companies not municipalities that have the power to tax.  Make SURE you know what you are getting into.

Also note that based on the above, the same rating for different types of historical bonds may mean different things - because the risk category of certain types of bonds is known to be higher risk.  So the "letter rating" is only in context to the type of municipal bond, just like the "crash safety rating" on a car is only relative to a collision with a similarly sized car.

What time-frames are available/advisable?

This is probably dependent on the size of the portfolio and when you might use the cash.  If you really are just holding too much cash, consider it an investment and thus probably targeting a longer duration.  The ability to call bonds (and a high frequency of it lately) makes duration interesting to manage.

Is "laddering" always a good way to set them up?

It depends on whether there is a specific purpose for the funds, but based on the OP, it is probably reasonable.  It's not the only way to do it, certainly, but good for lots of reasons.

notactiveanymore

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Re: Tax Free Municipal Bonds
« Reply #4 on: June 13, 2016, 08:58:36 AM »
Trying not to give too much away.... my employer is an electric commission made up of many municipal utilities and has about 1B in liabilities, entirely in municipal bonds. We have a 10% debt service coverage obligation to the issuers, so that is a bit of an insurance against default. There are other protections, but I don't want to get too specific.

We have A-range ratings from S&P, Fitch, and Moody's. We do an out-of-house audit every year, and all of our continuing disclosures and audits are published yearly on EMMA.

As for whether I'd feel comfortable with it, the returns you're getting right now are pretty low (good for me and mine lol!). But I would only feel comfortable with it if I dug in on EMMA and started getting a feel for the reporting on the bonds. I'd also look at credit rating strength. It's not easy for munis to get such high ratings without fail safes and strong financials and reserves. We require an audit from each of our member munis and we have big cash on hand requirements.

It's a whole different world. I'd want to understand it well before investing. That said, there are plenty of benefits.

wotan

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Re: Tax Free Municipal Bonds
« Reply #5 on: June 13, 2016, 10:03:11 AM »
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BFGirl

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Re: Tax Free Municipal Bonds
« Reply #6 on: June 13, 2016, 12:57:36 PM »
I have some municipal bond funds in my taxable account.  I'm in a state with no income tax, so I don't have worry about which state the bonds are from.

One advantage of the funds is that they are more liquid than holding the individual bonds, so you can sell them like you do stock funds (except the transaction doesn't go through until the end of the day).  If you hold the individual bond, you can still sell it before maturity but it will go through a broker and be sold on the secondary market, which could be in your favor or not.