What Is A Municipal Bond?
- Professional Definition — A debt security issued by a state, municipality or county to finance its capital expenditures. Municipal bonds are exempt from federal taxes and from most state and local taxes.
- Our Definition — Sometimes not all public projects can be funded by tax revenue. Therefore when a state, city, county or town wants to build public projects such as schools, bridges, highways, etc and needs to raise money, they take out a loan from the public in the form of a “Municipal Bond.” Oh and by the way you don’t pay federal taxes on the payments you receive from these bonds and in some cases no state taxes as well.
This type of investment is appealing to investors because your portfolio can generate safe and steady interest off of the return on municipal bonds.
Here is an example of a municipal bond:
Cowboy County would like to build a new road to their 5 year old football stadium which would help alleviate traffic. The road will cost $10 million to construct and the county is willing to pay 5% interest on a 10 year loan. (Municipal Bonds typically come in increments of $1000.) Therefore Cowboy County will issue 10,000 individual shares/bonds which will pay a 5% dividend.
The Problem With Municipal Bonds
As an investor you must always conduct your own analysis of individual companies/businesses but municipal bonds are a completely different industry than securities. You are in theory acting as a bank by lending money to the county for a set period of time while you collect interest on your money.
All in all Municipal bonds can be COMPARED TO certificates of deposits (CDs). The difference is you can sell your bond at anytime on the open market.
The main difficulty we see with municipal bonds is their minimum investment increments. At $1,000 you would need a hefty portfolio in order to be substantially diversified and build a sizable position. Don’t get me wrong, municipal bonds are some of the safest investments you can make especially when you have a reputable credit agency rating their bonds. However, nothing is guaranteed when it comes to investing.
If you don’t have $1,000 to purchase individual municipal bonds, then what are your other options…
Invest In A Bond Fund
There are mutual funds with very low expense ratios who specialize in municipal bond investing.
You can buy purchase shares of these mutual funds who hold hundreds of municipal bonds which are insured against default and collect a super-rich yield.
For example, one of the funds we invest in is the Invesco Value Municipal Income Trust (IIM). This fund holds investment grade bonds from several states, including California, Texas, and Colorado. It spreads your risk across a variety of bonds and right now it’s paying a 5% yield on your investment. Please don’t forget this 5% is tax free.
A word of caution, before you go rushing into any investment you always need to know the value of what you are investing in. Mutual funds and Exchange Traded Funds use what is called “Net Asset Value” (NAV) in order to value their shares. In short, NAV calculates all the assets in the fund and subtracts the liabilities (fees, expenditures, etc). With that said, when purchasing a mutual fund or ETF you would ideally like to purchase at a discount to NAV instead of a premium.
Here is a the NAV history of Invesco Value Municipal Income Trust from 2006 – 2015
As you can see for the past 10 years the NAV has floated between $12 – $17. However, the closing price has almost always been at a discount to the NAV. This means purchasing shares of this municipal bond fund would have made perfect sense most of the time.
Return On Municipal Bonds
Imagine if you invested $10,000 in this fund when your first child or grandchild was born and planned to reinvest every single dividend up until they reached 18 years. Remember, these are monthly payments which significantly boost compound interest.
Here are the results:
- If you never invested another penny.
- If the dividend never increased.
- If the fund never appreciated in value
By the age of 18, your child or grandchild will have an investment which yields 13%/year tax free. We cannot think of a better gift to help a young man or woman start off their life when leaving home.
Things to Remember
This is not an end all be all investment strategy. While we are in a world of nearly 0% interest rates and an inflation rate of 3.5% a tax free 5% income stream is nothing to balk at. But we want to be very clear, we could do much better with individual securities over time. Our main objective with this municipal bond funds is to preserve our capital while generating a tax free income stream.
Here are a few ideas/instances we can see these funds being implemented with families:
- Revenue generating savings account: Take your monthly savings allowance and contribute it to a municipal bond fund. When you decide to buy whatever you’ve been saving for, use the monthly dividends to pay for it.
- Gift giving account for relatives: As we pointed out earlier, you can implement this strategy for loved ones. We personally take 50% of all cash gifts given to our children and put into municipal bond funds.
How would you use a fund like this? Do you own any municipal bonds?