Municipal Bonds For The Retail Investor

By Bill Addiss of Online Trading Academy

Friday, August 10, 2018 4:55 AM EDT

A municipal bond (muni), is a debt security issued by a state, municipality, county or municipal entity to finance its capital expenditures (including construction projects) or for general financing of that municipality. The size and scope of this market is impressive.

There are over 50,000 different issuers of municipal bonds, resulting in over 1 million different issues outstanding in the U.S. In fact, as of 2017, the total value of all municipal bonds was almost $4 trillion. Most municipal bonds are exempt from federal taxes as well as most state and local taxes, which can make them especially attractive to retail investors, particularly those in high-income tax brackets.

Broadly speaking, there are two types of municipal bonds.

What Are the Two Types of Municipal Bonds?

General Obligations (GOs)
Revenue bonds (Revs)

What is the Difference Between General Obligation Bonds vs. Revenue Bonds

A general obligation bond (GO) is issued by a state or city and is not backed by revenue from any specific project. Instead, these bonds are backed by the general taxing authority of the municipality which can include, sales tax, property tax and income tax. Therefore, these bonds have multiple sources of revenue (predominantly taxes) backing the security.

By contrast, a revenue bond, (Rev) is a bond which is secured by the revenue generated by a specific project (such as toll roads, bridges, convention centers, stadiums). These bonds are like loans for projects where the bondholders will receive interest and their principal from the revenue generated when the project is completed.

Benefits of Investing in Municipal Bonds

What makes municipal bonds most attractive is the tax status on interest income received. Unlike corporate bonds which are fully taxable to the investor, municipal bonds offer the following tax advantages:

Interest Income from most municipal bonds is exempt from Federal Income Tax
If the bondholder resides in a state with a state income tax, the municipal bond income can be exempt from state income tax if issued within the buyer’s state of residency
If the investor resides in a city with city income tax, interest income can also be exempt from city income tax, also based on the bond buyers residency.

This means the interest income from municipal securities can be triple tax exempt for municipal bondholder, living in a state and city which taxes income, provided they buy a bond issued within the city in which they reside. Of course, if your state has no state income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) the triple tax exemption won’t apply, but you will still enjoy federal tax exemption regardless of what state the bond was issued in. This benefit is enjoyed by those investing in either General Obligation Bonds or Revenue bonds.

For any investor, what’s most important isn’t how much income you earn, but how much you get to keep after taxes. For that reason, municipal bonds offer particular appeal in today’s market.

Bond Yield Illustration:

For example, recently the NY State Turnpike authority issued a 5% coupon municipal bond, maturing in 2032. The bond was A rated by both Moody’s and Standard & Poors.

The question is, how much would an investor have to earn on a taxable investment to equal what they get to keep by earning 5% tax-free? The formula for determining the Taxable Equivalent Yield (TEY) is:

Taxable Equivalent Yield = Tax Free Income / (1-Tax Rate)

8.11% = 5% / (1 - .384)

A New York Resident earning $100,000 is in the 38.4% Tax Rate (Fed rate 28% + NY State 6.5% + NY City 3.9% = 38.4%). Using the formula above, we see that a NY Resident would have to earn 8.11% on a taxable investment to equal what they get to keep by earning 5% tax-free. Where 5% tax-free is achievable in the high-quality municipal bond market, 8.11% is not achievable in a similar quality taxable investment like a corporate bond.

Other Bond Considerations:

Insured Bonds

Some municipal bonds are insured or backed by policies written by insurance companies. In the event of default by the issuing municipality, the insurance policy provides for the insurer to pay principal and interest payments to bondholders. Therefore, Investors should take into account the creditworthiness of both the insurer as well as the issuer when considering bonds insured in this manner. In the terminology of the marketplace, these bonds are credit enhanced by the insurance guarantor.

Bond Funds

Because of the almost overwhelming size and scope of the marketplace, many investors often choose to buy municipal bond funds, rather than invest in individual bonds. Because the tax benefit to the investor is based on their residency, the mutual fund industry offers funds that are state specific. For example, a resident of California would want to buy municipal bonds only issued within that state and would, therefore, invest in a California State Municipal fund. Many mutual fund families offer such state-specific funds.

A resident of a state with no state income tax would be most likely to invest in what is called a national series. Since they have no state tax to consider, they can invest in a fund that invests in municipals issued anywhere in the US, not confined to just their state of residence.

A cautionary note:

Although not a large sector of the market, there are some municipal bonds which do not offer the tax advantages described above. When purchasing municipal bonds, make sure that the bonds do in fact offer the tax-free advantage.

How to Buy Municipals

Like all bonds in the US, municipal bonds do not trade on exchanges but rather in the Over-The-Counter (OTC) market. Therefore, to buy individual bonds it is necessary to work with a broker. Most national and regional brokers maintain a daily inventory of municipal bonds which they offer to individual investors. Some states also offer residents the opportunity to buy new issues directly. Additionally, most mutual fund families such as Fidelity, American Funds and Blackrock offer state and national series of municipal bond funds as described above.

The primary regulator for municipal bonds in the US is the MSRB (Municipal Securities Rulemaking Board). They have a very informative website on how to buy municipal bonds and municipal bond funds.

Also, because municipals trade in the OTC market, the regulatory body, Financial Industry Regulatory Authority (FINRA), has certain regulatory oversight as well. They too offer a very informative online brochure on how to invest in municipal bonds.

Disclosure: I understand that Online Trading Academy instruction will prepare me to actively trade securities and/or other financial instruments for my own account at an appropriate financial firm which utilizes the Electronic transmissions of securities and other financial instruments orders to execute trades for its customers. I understand that this course is not preparation to be a Licensed Broker in the financial industry and will not help me get a job.

Online Trading Academy Training Program should not be construed as a recommendation or an offer to buy or sell any security or the suitability of any investment strategy for Student. The purchase, sale, or advice regarding any security, other financial instrument or system can only be performed by a licensed Industry representative; such as, but not limited to a Broker/Dealer, Introducing Broker, FCM and and/or Registered Investment Advisor. Neither Online Trading Academy nor its representatives are licensed to make such advisements. All purchasers of the Online Trading Academy Training Program or other Online Trading Academy products are encouraged to speak with a licensed representative of their choice regarding the appropriateness of investing/trading or of any particular investment/trading strategy.

Online Trading Academy training centers are independently owned and operated and each location may set its own fees for classes.

A Note About Terminology Used on our Website

As used on this Website and in our communications, the word "professional" or "Professional" is used as an adjective to describe the exceptional quality of our education and the high standards we require of our instructors and personnel in all our Centers. None of our courses will provide education to become a Licensed Broker in the financial industry, or licensing in any other profession, and no course of instruction will lead to any job, employment or professional certification.

As used on this Website and in our communications, the word "Graduate" or "graduate" means any person who has experienced our Core Strategy Courses (previously called Professional Trader Part 1 and Part 2) and any person who has experienced any other combination of classes which total at least seven full days of our trading and investing education.

We Help You Minimize Trading Risk

At Online Trading Academy, we understand the risks involved in short term trading and emphasize risk management in our classes. Enroll in one of our free seminars to find out more!

Understanding Trading Risks

Electronic active trading involves special risks and may not be suitable for everyone. Electronic active trading may also involve a high volume of trading activity. Each trade generates a commission and the total daily commission on such a high volume of trading can be considerable.

Electronic active trading accounts should be considered speculative in nature with the objective being to generate short-term profits. This activity may result in the loss of more than 100% of an investment, which is the sole responsibility of the customer. An electronic active trader should understand the operation of a margin account under various market conditions and review his or her investment objectives, financial resources and risk tolerances to determine whether margin trading is appropriate for them. The increased leverage which margin provides may heighten risk substantially, including the risk of loss in excess of 100% of an investment.

STATEMENT BY CHAIRMAN ARTHUR LEVITT SECURITIES AND EXCHANGE COMMISSION CONCERNING ON-LINE TRADING
JANUARY 27, 1999

Chairman Arthur Levitt today issued the following statement to investors:
The Internet and other new technologies are in many ways transforming how our capital markets operate. There are clear benefits to these changes including lower costs and faster access to the market for investors. I believe that investors need to remember the investment basics, and not allow the ease and speed with which they can trade to lull them either into a false sense of security or encourage them to trade too quickly or too often.

Over the last two years, particularly in recent months, the SEC has been hearing concerns about retail, on-line (Internet) investing. In fact, the number of complaints concerning on-line investing has increased 330 percent in the last year. Some of the issues raised specifically relate to on-line trading, others are generic to all investing. The majority of them can be addressed through better education and investors ensuring that they have done their homework.

Every day, more and more Americans are investing in the stock market, and many of them are doing so through the Internet. On-line brokerage accounts account for approximately 25 percent of all retail stock trades. And, the number of on-line brokerage accounts is expected to exceed 10 million by the end of the year.

While the manner in which orders are executed may be changing, the time-honored principles of evaluating a stock have not. An investor's consideration of the fundamentals of a company-net earnings, P/E ratios, the products or services offered by the company-should never lose their underlying importance.

Investing in the stock market-however you do it and however easy it may be-will always entail risk. I would be very concerned if investors allow the ease with which they can make trades to shortcut or bypass the three golden rules for all investors: (1) Know what you are buying; (2) Know the ground rules under which you buy and sell a stock or bond; and (3) Know the level of risk you are undertaking. On-line investors should remember that it is just as easy, if not more, to lose money through the click of a button as it is to make it.

In recent months, we have begun to identify a number of issues every on-line investor should be aware of. First, investors must understand the issues and limitations of on-line investing. You may occasionally experience delays on these new systems. Demand has grown so quickly that many firms are racing to keep pace with it. In the meantime, you may have trouble getting on-line or receiving timely confirmations of trade executions. You should not always expect "instantaneous" execution and reporting. There can and will be delays in electronic systems. You should investigate and understand options and alternatives to executing and confirming your orders if you encounter on-line problems.

Second, investors may sometimes be surprised at how quickly stock prices actually move. For example, many technology stocks have recently had dramatic and rapid price movements. When many investors attempt to purchase (or sell) the same stock at the same time, the price can move very quickly. Just because you see a price on your computer screen doesn't mean that you will always be able to get that price in a rapidly changing market. You should take precautions to ensure that you do not end up paying much more for a stock than you intended or can afford.

One way to do this is to use limit orders rather than market orders when submitting a trade in a "hot" stock. The result for investors that do not limit their risk can be quite surprising. Say an investor wanted to buy a stock in an IPO that was trading earlier at $9.00 and failed to specify the maximum they were willing to pay using a limit order. That investor could end up paying whatever price the stock has moved to at the time his order reaches the market -- $60, $90 or even more. If, on the other hand, the investor submitted a limit order to buy the stock at $11.00 or less, the order would only be executed if the market price had not moved past that level. Investors should understand the risk associated with trading in a rapidly moving market and make sure that they take all possible actions to control their risk.

Third, I am concerned that investors buying securities on margin may not fully understand the risks involved. In volatile markets, investors who have put up an initial margin payment for a stock may find themselves being required to provide additional cash (maintenance margin) if the price of the stock subsequently falls. If the funds are not paid in a timely manner, the brokerage firm has the right to sell the securities and charge any loss to the investor. When you buy stock on margin, you are borrowing money. And as the stock price changes, you may be required to increase the cash investment. Simply put, you should make sure that you do not over-extend.

Fourth, while new technology available to retail investors may resemble that of professional traders, retail investors should exercise caution before imitating the style of trading and risks undertaken by market professionals. For most individuals, the stock market should be used for investment not trading. Strategies such as day trading can be highly risky, and retail investors engaging in such activities should do so with funds they can afford to lose. I am very concerned when I hear of stories of student loan money, second mortgages or retirement funds being used to engage in this type of activity. Investment should be for the long-run, not for minutes or hours.

Millions of new investors have taken advantage of the unprecedented access and individual control the Internet provides. But, new opportunities present all of us with new responsibilities, challenges and risks. The SEC will do everything it can to protect and inform investors during this time of great innovation and change. But, investor protection-at its most basic and effective level-starts with the investor. I say to all investors-whether you invest on-line, on the phone, or in-person-know what you are buying, what the ground rules are, and what level of risk you are assuming.

Important Information about trading Foreign Exchange.

Trading foreign exchange is not for everyone. Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.

For UK Complaints Procedures, click here

less

How did you like this article? Let us know so we can better customize your reading experience.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.