When an investor goes to purchase a municipal bond, it is important to understand all the attributes of the municipal bond.
A bond transaction screen, such as this one from Schwab.com show investors the State issuing the bond, the credit rating, the bond ‘s description, the CUSIP number, the coupon (interest rate payment), the maturity date, the price, the yield to maturity, whether the bond is taxable, callable, the accrued interest and the estimated costs to buy the number of bonds.
Accrued interest is interest that accumulates between coupon payments to an investor. A callable bond, is a bond that can be re-purchased by the issuing municipality at par, after a certain period of time.
Most online brokers will allow investors to search for bonds by criteria.
Checking historical transaction data on a trade will allow you to defend against poor pricing. Dealers make money on spreads, and you need to protect yourself from being ripped off. Enter the CUSIP number to get information about the bond from investinginbonds.com.
In general, purchases of increments of $25,000 or larger will minimize the spread or markup and will allow you to receive the best possible price. Investors should always use multiple brokers, and speak directly with bond desks and salespeople. Unfortunately, many municipal bonds are illiquid which means buying and selling of specific bonds are by appointment through numerous market makers or brokers. The online systems show marked up prices and pricing is opaque. Commissions can vary, and are different depending on whether you are dealing directly with a principal who has the bond or through an agent.
Starting in 1984 per the MSRB, municipal bond dealers are supposed to disclose material facts about a municipal bond to buyers. Unfortunately many dealers have to ignore this requirement. FINRA now has a 7 page checklist per customer disclosure that has even more requirements including covering bond pricing with customers, explaining why securities are priced the way they are, and educating buyers on the inverse relationship between price and yield of municipal bonds.
Keep in mind that the municipal bond market is not as liquid as the stock market. Many municipal bond issues trade every couple days or so, not every second like stocks. Most individual investors buy and hold bonds to maturity.
Principals are dealers who hold inventories of bonds in their portfolio and are willing to make you a price on the bond. In general, principals make their money on the spread they charge for either buying or selling a bond, and charge a lower commission than an agent. An agent is a broker, who will look for the best price amongst numerous dealers, and charge a commission for that service. Principal dealers act as brokers as they do not have the bond in their inventory.
Beware of dealers trying to dump bonds. You might even be told that the bond you are looking for is not available, but they have an alternative that holds the same yield. Make sure you perform research prior to accepting a new bond.
If you buy a discounted bond below Par or 100, you will pay taxes on the discounted amount at maturity. For example, if you pay $950 for a Par $1000 bond, at maturity you will pay taxes on $50.
Building a duration ladder of bonds will require buying short, medium and long-term bonds. The ladder will protect you from different types of risk. Shorter-term bonds, less than 2 years, are protection from market risk, since you can take them to maturity easily. Medium term bonds, 3-8 years, give a better yield than short-term bonds, with higher market risk. Longer term bonds 10+ years, have the largest payouts, but the highest risks.
If a bond appreciates, a sale will create a capital gain, if sold beyond one year. Prior to a year, the sale will create ordinary income. Therefore, an investor should take into account the tax ramifications of his entire portfolio as one of the factors in determining whether to sell a bond. When bonds trade above their initial offering price, or Par, they are considering to trade at a premium. When they trade below this price, they trade at a discount. Bonds that trade at a premium, offer lower yields than the initial issue yield, and occurs because the demand for the bond is high. The reverse is true for a bond that is trading at a discount.
Bonds usually pay interest at the end of the year, so many bond investors reinvest this interest in January of the following year, causing a slight lift the municipal bond market.
Bonds, like other assets will appreciate or depreciate and the decision to sell a bond is based on numerous factors. Some investors sell their bonds because they need the money, but there are other factors that should be considered including: Selling before interest rates rise, or you decide to take profit.
When a municipal bond is sold, the interest that is accrued between the coupon payment dates goes to the bondholder of record. For example, if a bondholder on a semiannual bond sold $1,000 of a bond that was paying 6% with semi-annual payments half way through the coupon date, the buyer would pay the seller 50% of the 3% that accrued. The accrued interest is added to the agreed price. Bond buyers should understand that the total return that is received from owning a bond is equals principal plus income plus any capital gains.
Buying and selling individual bonds requires an active posture, similar to the way you would purchase stocks or real estate. You need to do your homework and find all the benefits and risks of each bond. Successful bond investors become robust bond collectors. They look for quality issues all the time that they are proud to hold in their portfolios.
Selling a bond has become more difficult after the credit crisis, as many fewer bonds change hands each day now. In order to find a good price, you need to work with multiple dealers.
Each time a bond matures the investor needs to reinvest the capital in a new bond. If you do not want to be an active bond investor, there are more passive ways to invest.
Monitor your bond portfolio
Managing your portfolio is like managing a business. Most businesses are not on autopilot and if you want solid returns and no ugly surprises, it is important to keep yourself abreast of issues that could alter your intended returns. Watch for downgrades, project problems, state problems, and interest rate changes. Read the Wall Street Journal and local papers, and set up alerts on Google News and Morningstar. Review your brokerage statement. Look for “Material Event” (ME) on monthly statements next to your bond for notification of problems.
Watch news global macro – interest rates
As prices change for bonds, either higher or lower, your returns are affected by your decisions to undertake capital gains or losses. A good rule of thumb is to offset gains during a calendar year with loses. In any market, you want to cut your losses and let your profits run. When confronted with losses, determine if the current market value of your bonds is under or overvalued, and combine that with your thoughts on the total return and alternative investments, to make a decision on whether your should continue to hold the instrument.
Municipal bond research resources
- napfa.org – locate financial planners
- brokercheck.finra.org – check on a broker
- adviserinfo.sec.gov – check out an investment advisor or advisory firm
Additional Related Municipal Bond Educational Articles:
What are municipal bonds?
How to Research Municipal Bonds
The Risks of Owning Municipal Bonds
How to Buy And Sell Municipal Bonds
Municipal Bond Mutual funds – Municipal Bond Managed Accounts
What Are Closed-end Municipal Bond Funds?
What are Municipal Bond Exchange Traded Funds or ETFs
How to Make a Municipal Bond Ladder
How to Select Municipal Bonds
Municipal Bond Trading Example
How to Perform Active Municipal Bond Management
Municipal Bond Books and Educational Resources