Municipal Bonds
What Are Municipal Bonds?
Municipal bonds are loans issued by state and local governments for permanent
long term financing of bridges, roads, water and sewer systems and schools. Long
term bonds are usually issued for these projects because they are too expensive
to be financed out of tax revenues in a single year.
The two broad classes of long term loans issued by municipalities are called
general obligation and revenue bonds. The difference is in the source of revenue
used to pay the principal and interest on the bonds.
General Obligation Bonds are backed by the "full faith and credit" of
the community. This means the source of revenue is from tax receipts.
Revenue Bonds have a more limited backing. The source of revenues that
back these bonds come from specific projects developed by governmental agencies.
Example of these revenue authorities are Massachusetts Turnpike Authority,
Massachusetts Water Authority, New Jersey Turnpike Authority and New York State
Tri Borough Bridge and Tunnel Authority.
Recent years have seen a growth of non-traditional financings called
"private-activity" bonds. These bonds are used to support a specific
constituency. Some examples of these bonds are mortgage revenue bonds, student
loan bonds and pollution control bonds that a state can issue. The Federal
Government imposes volume limits on the issuance of these types of loans.
However, there are several categories of private activity bonds that are
"exempt" from these federally imposed limits. Some example of these are
airports, docks and wharves and solid waste facilities.
Am I the Type of Investor That Should Be Investing in Municipal Bonds?
The typical municipal bond investor is an upper income individual or family
that is interested in the preservation capital and a predictable stream of
revenue. Municipal bonds offer the opportunity to invest capital safely while
receiving after-tax income that is higher than that available in other fixed
income investments.
I Have Noticed That Yields on Municipal Bonds Are Always Lower Than
Comparable
U.S. Treasury & Corporate Bonds. Why is This the Case?
Because the yields offered on U.S. Treasury securities and on Corporate bonds
are before taxes are paid. Municipal bond investors are willing to accept lower
nominal yields on their bonds because the income is free from Federal and
perhaps local and state taxes. You have to make an after-tax comparison of a
municipal bond offering and a comparable taxable bond offering to make an
intelligent decision on which investment to make.
Can You Please Give Me a Real Life Example? This Sounds Very Confusing.
Sure. Its really very simple. On December 26th 2000 U.S. Treasury bonds and
AAA municipal bonds were yielding a 5.03% and a 4.37% respectively. A top income
bracket individual after paying 39.6% federal tax on the U.S. treasury bonds is
left with a 3.03% after tax return. Since no federal taxes are paid on the
municipal bonds, the investor will receive substantially more income buy
choosing to invest in municipal bonds.
Why Should Atlantic Financial Manage My Municipal Bonds Investments
Separately Rather Than a Mutual Fund?
Separate account portfolio management is less costly and more tax-efficient
for individuals with at least $100,000 to invest in the municipal bond market.
In addition, investors will have portfolios created and managed individually to
meet their personal financial objectives.
How Safe Are Municipal Bonds?
Bond investors are subject to credit risk and market risk.
Credit Risk is the ability for issuers to meet its obligations in a
timely fashion. Municipal bonds historically have a default rate of less than
1.5%. The riskiest sector of municipals are in private activity bonds. The
credit rating of an issuer is an effective way to judge the risk associated with
a municipal bond. The higher the rating, the more likely the issuer will make
timely payments (See
Bond Rating table).
Market Risk is associated with the fluctuation of interest rates. As
the level of current interest rates change, the price or market level of your
bonds change. The market price of a bond will increase as the level of rates go
down. Subsequently, a bond will lose value if interest rates rise. If you bought
a 5.0% municipal bond at par and interest rates went down to 4.75% your bonds
would now be worth a premium. This is especially important if you were to sell a
bond prior to maturity because the sale could generate a capital gain or loss.
What is Bond Insurance?
There are insurance companies that will guarantee timely interest and
principal payments for municipal issues in the event of default. This insurance
is designed to reduce the risk of loss to investors. Most of the major bond
insurers claims paying ability are rated AAA, so any bond they insure will also
be rated AAA. Over half of the new issues priced in 2000 were brought to the
market with some type of credit enhancement. The benefit to investors is that
the insurers will accept the risk in the event of default.
Real Life Portfolio Examples
Current Income Investor (current income portfolio)
John, a newly retired 59 year old IBM executive, sells his Newton, Mass home
and heads west to Santa Fe. He reinvests his $1.5 million home proceeds in a
high quality, laddered municipal bond portfolio. His new investment provides
John and his wife $70 thousand dollars of tax-free income[a].
Funding Investor (funding portfolio)
Mr. and Mrs. Davidson decide to allocate their bonuses to funding college
tuition costs for their 10 year old daughter. Using the help of a financial
planner to predict future college expenses, they invest in zero coupon bonds
that will completely fund their child's education.
Total Return Investor (total return portfolio)
Nancy and John are sophisticated and aggressive investors. They believe that
long term municipal bonds[b]
offer attractive yields and have the potential for capital appreciation. For
this reason they decide to allocate 65% of their portfolio to equities and 45%
to high quality municipal bonds.
Municipal Bond Portfolio Objectives
Here are some bond portfolio possibilities with Atlantic Financial:
Current Income Portfolios
The objective of this portfolio is to provide tax-except income[a]
that can be used for living expenses. We construct a well diversified portfolio
with respect to credits and maturities.
Funding Portfolio
The objective of this portfolio is to fund a future goal such as a college
education or retirement. Atlantic Financial creates diversified portfolios that
reinvests all coupon income and capital appreciation to fund the objective.
Total Return Portfolio
The objective of this portfolio is to maximize investor returns over a period
of time from both income and capital appreciation.
Bonds
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