When it comes to investing in bonds issued by local municipalities, how do you know where to start? Investing for tax-free income can be an important component of a well-diversified portfolio, but the municipal markets are complex and best navigated by an experienced professional. I’d like to share some ideas that I have gathered over the years as an Institutional Fixed Income Trader and as a Registered Investment Advisor. My philosophy is that it is important to keep your “safe” money safe, so I tend to have a conservative bias. Here are a few important ideas to help you get started:
Diversify – Be sure to split your portfolio among several different issues. I will go into more detail below about diversifying by issuer and maturity, but let’s start with the basics. There is no magic number, but you also want to avoid “over diversifying,” because transaction fees can add up quickly and a portfolio can become too complex to monitor. For a $100,000 South Carolina tax-free portfolio you might invest up to $25k in a South Carolina State bond, and then add 5-7 highly rated City and County issues in $5k-$15k increments, depending on what bonds are available.
Start with General Obligation Bonds – While Revenue bonds are backed by fees collected by specific projects such as recreation centers or toll roads, General Obligation (GO) bonds have the full faith and backing of the issuer. The municipality has a moral obligation to repay the bond, which provides investors with enhanced security of both principal and interest payments. The state of South Carolina has a solid credit rating (as do many states for those of you across the country), so state-issued bonds are a good starting point. From there, you can evaluate the finances of various cities and counties and look for pockets of strength. I have a short list of 8 issuers here in South Carolina that I start with for the core of a portfolio, and I expand from there. I follow the same methodology for residents of other states, starting with the state-issued GO’s and then layering in GO issues of the most financially sound cities and counties within the respective state. For proper diversification of higher dollar portfolios, I add in highly rated essential purpose revenue bonds such as water and sewer bonds. The underlying rating of your core portfolio should be AAA/AA, even if the bonds are covered by insurance on principal and interest payments.
Stagger Maturity Dates – It is impossible to predict either the direction or the magnitude of upcoming changes to interest rates. By staggering the years until maturity, you can structure your portfolio to have bonds coming due each year in case you need the money down the road. I recommend that newer municipal bond investors begin with short-intermediate term bonds with no longer than 10 years until maturity. This helps balance the risk of changing interest rates. If rates rise, you will have the short-term bonds coming due that you can reinvest at the higher rates. If rates fall, you will be glad that you locked in the higher rates of the 7-10 year bonds. South Carolina is a smaller state, but even here there are plenty of good municipal issuers to build a diversified portfolio with various maturity dates. Municipal coupon bonds pay interest twice a year, so by staggering the months of the interest payments, you can generate a steady stream of monthly income. You need just 6 different bonds to receive interest income each month of the year – Jan/Jul, Feb/Aug, Mar/Sep, Apr/Oct, May/Nov and Jun/Dec.
Monitor your Bonds – Just like with the equity side of your portfolio, it is critical to monitor your municipal bond holdings. The media can become alarmist with the municipal market in the same way they can with the stock market, so keep a cool head and remain objective when negative headlines come out. I monitor local economic trends and growth demographics, large employers entering or exiting certain areas, housing and employment data, and, most importantly, the overall financial soundness of specific municipalities. If a bond rating is changed, I immediately dig into the details of “why” to see if we need to re-evaluate.
Before I go, let me share a few caveats:
- Remember, this is just one part of a comprehensive financial plan and investment portfolio
- Double-check with your CPA to make sure muni’s are appropriate for you, especially if you are subject to AMT
- Look for quality – don’t focus on finding the highest yield, usually this is an indicator of some type of underlying risk
- Check the tax exempt status of a bond before you buy
- Avoid haphazard bond buying and incorporate structure into your portfolio
- Be sure you know about early redemption features the bond may have and how this may affect your yield
- Municipal bonds are generally not suitable for tax-deferred accounts like IRA’s, since their interest is already tax-free
- Be sure you know the difference between discount and premium bonds
Personally, I think one of the most exciting places to invest is in your local communities. Emerging markets and upcoming “hot” initial public offerings of stock make for exciting cocktail party conversation, but municipal bonds offer a way to add stability to your portfolio while supporting your state and local communities. Here in South Carolina, and in all states, tax-free municipal bonds are issued to support our schools and local services. The municipal market is one of the most complex investment markets in the world, even here in South Carolina. If you focus on quality and do your homework, you can successfully build a solid portfolio of tax-free municipal bonds. Feel free to drop me an e-mail if you have any questions or need any help, I love receiving questions!
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Will an out of state municipal bond have a south Carolina income tax placed on it?
Typically yes, Ricky, and some municipal bonds are fully taxable.
How do we find out if a school bond purchased in the 70 s still holds value?
Hi Dana, happy to help you – do you have the physical bond? If so, you can scan a copy to me and I will find out for you. email@example.com