The only time most investors hear about municipal bonds is for negative reasons, be it the bankruptcy of Stockton California or the forecasting of local meltdowns. According to Mark Martiak of Premier/First Allied Securities, municipal bonds, or munis, shouldn't be given such a bum rap. In this episode of Investing 101, Martiak explains the risks, the rewards, and how to best invest in munis.
Benefits of Investing in Muni Bonds
Step one is obviously understanding what munis are. "Municipal bonds are fixed income investments that are tax exempt," explains Martiak. Breaking it down means that the income stream from munis is set, or fixed, at a constant rate. If you buy a bond yielding 5%, that's what you get: 5%. The rate is fixed regardless of what happens to the underlying bond.
As for tax exemption, municipals are exempt from federal taxes, increasing their effective yield. Using 5% as an example, if that bond were subject to a hypothetical 20% tax rate, the real yield would only be 4%. Muni yields are understated compared to a dividend stream.
Martiak says munis give investors a sense of ease with their investment from knowing the coupon will stay the same — barring a default. The price of the underlying bond may change, but your yield doesn't change, regardless of price.
Understanding Muni Bond Risks
Municipalities can fail, though not as often as you may be led to believe. "Historically the default rate in most States and municipalities has been very minimal," says Martiak. The best way to hedge this risk is through the old standbys: diversity and research.
Diversity means investing in both high yield and investment grade munis. Shooting for the highest fixed return is tempting, but putting all your eggs in one basket seldom, if ever, makes sense. Spreading your bets between collecting coupons from well-heeled communities and those with more questionable credit optimizes expected returns. Martiak generally "recommends that most investors stick to investment grade."
In terms of hands-on research, it's generally more difficult for the layperson to analyze the prospects of a town than it is a company. Municipal bond information is seldom splashed across the business section of your local paper or seen on television. Buyers can rarely go to a town and "kick the tires" on a bond investment the way they could a company in the business of a selling goods or services nationally.
Martiak says the safest way for most folks to buy into the municipal bond market is via ETFs (exchange traded funds), or notes designed to track returns across a variety of markets. Among the most popular are: iShares S&P National AMT-Free Muni Bond Fund (MUB), PIMCO Intermediate Muni Bond Strategy (MUNI), SPDR Nuveen Barclays Capital Muni Bond ETF (TFI), and PowerShares Insured National Municipal Bond Fund (PZA). Each has its own special "flavor" of investing in the market, and as always, investors need to do their own research to see which investment makes the most sense for them.