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How to Select Safer Municipal Bonds

Last update July 2015
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With over 20,000 municipal bonds in circulation, how does an investor select a municipal bond to purchase?  In our article What to Look for in a Municipal Bond , we describe some key details to look for in a municipal bond. In this article we drill down further and try to focus in on more specific attributes to look for in a safe municipal bond. This article will be updated from time to time to reflect new information we have dug up, and hopefully our readers help submit.

We have entered an era where educated bond pickers will do well, while those who blindly purchase municipal bonds, may counter issues. Obviously we would like to purchase of a municipal bond that is reasonably priced and provides the decent yield given this maturity date. Here are some specific attributes to look for in a municipal bond.

Fiscally stronger states: Arkansas, California (Avoid Central Valley), Delaware, Georgia, Maryland, North Carolina, South Carolina, Oregon, New Mexico, Minnesota, Texas, Tennessee, Virginia, and Utah are stronger than most of the other states.

Weak states include Rhode Island, Illinois, Michigan, New Jersey, New York, Nevada, and Pennsylvania. Puerto Rico is often listed as a state to avoid. An easy way to determine if state is weak is to look at its municipal bond spreads over a 10 year AAA municipal bond index. The wider the spread, probably the weaker the state. See this WSJ article for a map showing strong to weak states.

A recent analysis of states showing ones with the highest debt to GDP ratio in 2009 listed Connecticut, Hawaii, Maine, Alaska, and Oregon.

Essential Service Municipal Bonds

Obviously we should avoid general obligation bonds of these weaker states. Local projects within states need to be scrutinized carefully to ensure that essential services are backing these municipal bonds. Beware of water and other services requiring multiple agreements between different providers, these interconnections can lead to uncertainty and other problems. Is just a handful of customers paying for the services? Newly developed communities may have essential services that are much weaker than established communities. Weaker states and projects have to pay higher interest rates to attract investors, so try to avoid the temptation of chasing yield. We want to definitely diversify geographically. Only buy senior debt of essential services, as they have a better chance to be paid should problems arise.

47% of municipal bonds at the end of 2010 were tax secured, 13% are utility, 11% are US government, 9% for transportation, 9% are in healthcare, 5% or higher education, 3% are corporate backed, 1% our project finance, and the balance were Other.

14% of municipal bonds were state general obligation bonds, 10% were local general obligation bonds, 11% were insured bonds, and 9% were pre-refunded municipal bonds. 12% were transportation revenue bonds, 9% for special tax bonds, 7% were hospital bonds, 7% were water and sewer bonds, 6% were education, 5% were electric utilities, 4% were for leasing, with the balance in housing and resource recovery.

Be sure to read our article Analyzing Municipal bond Defaults

Also Avoid:

  • Pension Obligation Bonds

Seasonality

And increase supply in municipal bonds typically occurs from March to June, while a slowdown in the issuance occurs usually from December through January.

Attributes to avoid

Tobacco bonds because smoking rates are falling, possibly causing revenue assumptions not to be met, making default possible in the future.

PIK bonds, interest rate swaps, sub debt, bonds financed by property taxes, bonds financing assisted-living, and unrated municipal bonds.

If you buy mutual funds, avoid ones with low average credit quality, too long a duration, and ones that use leverage.

Attributes to look for

General obligation bonds of fiscally strong states, essential service bonds, pre-refunded bonds Backed by or escrowed by US Treasuries. Make sure they are escrowed with US Treasurys, not Fannie Maes, not Freddie Macs, not Guaranteed Investment Contracts–GICS. You can verify this by entering the bonds CUSIP number on MSRB.org

Insurance is no longer that important as less than 10% of bonds are now insured. There are no longer any AAA rated insurers to back municipal bonds like there were in the past. So the key is to look at the underlying rating of the bond, while ignoring insurance.

Look for bonds with high ratings from S&P, Moody’s, or Fitch. Most people define AAA or AA rated bonds to be the best bet. At the end of 2010, 20% of municipal bonds are rated AAA, 47% are AA, 25% are A, 6% are BBB, and 2% are below investment grade. Avoid unrated bonds and lower quality bonds.

Premium bonds are preferred. These are bonds that trade at a level above par or 100. If you purchase a discount bond, you have to pay income tax on the discount amount. With premium bonds you’ll get greater income, less volatility, but you will have to pay more in the beginning.

Those taxpayers affected by AMT should look for municipal bonds that are not subject to the AMT tax.

Kicker Municipal Bonds

As interest rates have fallen, investors seek to gain more yield. They are turning to a type of investment known as kicker bonds or cushion bonds.

  • Kicker bonds can be called sooner and unexpectedly
  • They sell at a premium
  • Income can be double that of regular municipal bonds
  • There is the potential for extra reward down the road
  • They accounted for almost 63% of the Municipal Bond Index in 2012, up from 30% in 2011
  • Downside occurs if the bond is paid back early
  • If they are not called early, you keep earning the high interest rate

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

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