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!

© 2013 Pawleys Investment Advisors, LLC. All rights reserved.

Most municipal bonds are found in the secondary market, meaning they were issued years ago, and the bondholder decided to sell their position in the open market. This is where people looking to invest new money in South Carolina tax-free municipal bonds can go to “shop.” Let’s look at a few examples and the different components of specific bonds (this is NOT an offering to sell securities, this is for illustrative purposes only):

10M BEAUFORT COUNTY SC GO BONDS 4% DUE 03/01/2015 106.59 0.341% YTM

10M CHARLESTON COUNTY SC PARK & REC GO BONDS 2% DUE 02/01/2016 103.77 0.623% YTM

10M HILTON HEAD ISLAND SC BONDS 4% DUE 12/01/2019 109.237 0.4245% YTM next call 12-01-2015 @ 100.00 2.474% YTC

The first example is a General Obligation bond issued by Beaufort County. Ten bonds cost $10,659 and the coupon or annual interest is 4% or $200 paid March 1st and September 1st until maturity on 03/01/2015, when the bondholder will receive return of principle of $10,000. The yield to maturity is 0.341%.

The second example is a Charleston County Parks and Recreation bond. Because the description says “GO,” we know it is a General Obligation bond backed by the full faith of Charleston County, as opposed to a revenue bond backed by some type of park or recreation facility user fees. Ten bonds cost $10,377 and the coupon or annual interest is 2% or $100 paid February 1st and August 1st until maturity on 02/01/2016, when the bondholder will receive return of principal of $10,000. The yield to maturity is 0.623%.

The third example is a Hilton Head Island SC bond that matures in 2019, but starting in 2015 the issuers may redeem or “call” the bond early. Ten bonds will cost $10,923 and the coupon or annual interest is 4% or $200 paid June 1st and December 1st until the bond is redeemed or matures on 12/01/2019, when the bondholder will receive $10,000. The yield to maturity is 0.341% and the yield if the bond is redeemed early in 2015 is 2.474%.

The three key components of any municipal bond are the issuer, coupon and maturity. When they are first issued, they are usually priced at par or 100.00, which means $5,000 per every five bonds. Almost all municipal bonds trade in increments of 5M or $5,000. You may purchase a minimum of 5M, or in increments of 5’s thereafter. Bond dealers used to trade in minimums of 25m and 25m increments, but with the enhancements of technology the minimums are now lower. South Carolina has many different issuers with various maturity dates to choose from, so it may take time but you can build a well-diversified portfolio of home-grown Palmetto state bonds!

p.s. if there is any material information relevant to the bond it must be disclosed. For example, if there has been a rating change you would likely see “ME” or “MATERIAL EVENTS” next to the bond description, and the dealer would provide you with additional disclosure.

© 2013 Pawleys Investment Advisors, LLC. All rights reserved.

What do you need to know about the tax-exempt status of your municipal bonds?  Quite a lot.  By no means I am an expert on municipal finance or tax code.  Many clients of Pawleys enjoy the safety and income of their South Carolina tax-free municipal bonds. Statistics show us that across the country, municipalities have a sound track record. It is a complex market, however, and every bond should be evaluated individually. Here are a few tidbits for you to consider as an investor seeking tax-free income.

There is a special department within the Internal Revenue Service called the Office of Tax Exempt Bonds.  This office acts as a resource to the world of municipal finance.  When state and local governments finance airports, hospitals, recreational and cultural facilities, schools, water and sewer infrastructure, roads, and facilities and equipment for police, fire and rescue services, the bond issues normally meet the standards for the interest paid to the bondholders to be exempt from federal, state and local taxation. 

The IRS code requires that the funds raised for such issues must meet certain requirements to ensure that the interest is not taxable.  The municipalities even have to follow certain rules after issuance to retain the tax-exempt status.  If any level of private activity is financed by a municipal debt issue, the bonds may lose tax-exempt status.   For example, if a private company moves into a facility previously used by local government, any outstanding bond issues that financed the building are at risk of losing tax-exempt status.  Normally in this type of situation the municipality will “defease” or call the bond in early and pay remaining principal and interest to the bond holders.  Bonds issued that may support private activity such as hospitals, ports (air or water!), or industrial facilities may be at risk of not having or losing tax exempt status.  Municipalities are also disallowed tax exempt status from certain “arbitrage” situations where debt is issued and the money raised is then reinvested in higher interest securities.

When you invest for tax-free income, you might consider starting with highly rated “general obligation” bonds that are backed by the full faith of the issuer.  These may include general state, county or city issues, or even local school bonds.  “Revenue” bonds generally pay a higher rate of interest, but as you read above, may be very complex to understand even for the most seasoned investor or advisor.  Be sure to check the bond indenture to know exactly how proceeds from the bond are being used, and double-check the underlying financial condition of the issuer or project, especially on revenue-backed bonds.

Municipal bonds have a strong track record and historically low default rate, but be careful as you venture into this intricate market.

© 2012 Pawleys Investment Advisors, LLC.  All rights reserved.