I invest in municipal bonds. They serve as a place to park my cash (very short-term munis used in money market accounts) and as a component of fixed income of my portfolio (longer term maturities).
But I also buy individual issues when they're mispriced. Nine to twelve months ago was a great time to pick up some bargains. Now, some bargains are back, but one must be careful, as munis have two sides, a reasonably safe one and an unsafe one.
The safe side
General Obligation municipal bonds (GO bonds) are typically tax-free obligations of the state, backed up by its taxing authority. That means that the state must do what it takes to pay them back, including raising taxes. So, unless a state becomes empty or some huge unheard of crisis hits, GO bonds should be a relatively safe investment.
But they typically don't trade much below their face value and as such good deals are hard to find. One must look constantly for temporarily mispriced issues or other inefficiencies in the market.
Not all GO bonds are "safe" since states can still default or issue IOUs.
The unsafe side
Revenue muni bonds are typically not backed up by the full-faith and credit authority of the state. They typically represent an investment by the state in a particular revenue-generating project such as a hospital, toll road, utility company, etc.
In most cases, these bonds are guaranteed only by the revenue generated by the project. In some other cases, they are backed up by special taxes imposed on certain people (residents of an area or district) or company or both. But these taxes can't be arbitrarily increased to back up the bonds.
While "unsafe" in nature, revenue bonds can be very safe investments if chosen wisely. There are opportunities lurking in plain sight in this area.
What to look for and how to tell them apart
When I search for muni bonds, I totally disregard credit quality (those letters such as "AAA", "B+", etc issued by Moodys, S&P or Fitch). Why? Because if I look at credit, I'll be delegating to the rating agencies the assessment of riskiness of the bond. After all, it's part of my job as an investor to find those "B-" or "B3" bonds that are really "AAA" in my assessment but that are mispriced by the market (because it blindly follows credit ranking).
Maturity, yield and price. I start my search by ranking muni bonds per maturity, yield and price. The higher the yield, the best. But I prefer to see the yield being high because the price is low, not because it was issued at high yield to begin with. This is because when projects are high-yielding from the start, it's likely to be a high risk project. But they're fine too, as long as I understand the risks. I like the price to be below par and the maturity to be as short as necessary for me to get a good yield-to-maturity.
Prospectus. Once I'm interested enough in the maturity, price and yield, I go read the prospectus. Just like a company's IPO prospectus, a muni bond has a similar document too. I look it up at the Municipal Securities Rulemaking Board's website. That's where I get to know for sure what the proceeds are going to be used for, what (if anything) guarantees my principal and my interest and all other terms that I'm looking for.
Who/What Guarantees My Principal. This is one of the first things I want to know, even if it's obvious from the description of the bond. The prospectus clearly says if the state guarantees it based on its taxing power (GO bonds) or not and if not, what, if anything, backs it up. Sometimes, there's nothing backing it up, just the full-faith and credit of some private company. Run from these unless you know something about the private company in question. If special tax revenues back the bonds, go find out how many people/businesses pay this tax and how much they pay per year and what's the situation in that specific area.
Insurance. Some bonds are insured by private companies. This sounds like a good thing but it really isn't necessarily and many investors miss this. First, in most cases, the insurance is for the interest, not the principal. If the state defaults, you may still lose your principal. Second, historically, the default rate on muni bonds has been low, and insurance companies know this, so they may take risks and insure more than they can realistically afford to. Now an investor has to look at the credit worthiness of the insurer and we don't trust the rating agencies, so it's more work.
Finally, (and here is the counter-intuitive part) if faced with the possibility of default, states would probably be more likely to stop paying interest on the insured bonds as opposed to the uninsured ones. Why? Because then no investor would be harmed by the state, right? After all, the state is paying for the insurance, it might as well use it when needed. That means, insured bonds are probably the first to be defaulted on and if too many of these cases happen, the insurer goes broke and the investor gets the bill. I try to avoid insured issues when other opportunities exist.
Sinking Fund. This is not as big a deal as it sounds. A sinking fund is cash set aside periodically to pay off the debt. It's typically a good thing to have, but is not a big deal in most cases. One must still look for it because it's possible in theory (though, rare) that in exchange for the safety of the sinking fund, the bonds are only redeemable at a discount of their face value. If that's the case, you need to readjust the face value and recompute the yield accordingly, if your broker or search site hasn't done so.
Call Feature / Redemption Provisions. Bonds can be called (paid for and terminated) prior to their maturities. This is typically seen as an added risk, because it limits the return an investor will get. When times are good, borrowers pay off their debt ahead of time and issue new bonds with less attractive terms. However, and here's the rub most people miss, a call feature can be a good thing if one buys a bond at a big discount. By redeeming my long-term bond before its maturity, I realize the capital gain upside earlier, because bonds are typically called at par. This means I don't have to wait until maturity and the price converges to par immediately as opposed to over time. For some of the bonds I buy, the capital gain portion can be a bigger upside than the interest paid over time.
Tax-Free, AMT Status. Believe it or not, some revenue bonds are not really tax free. I pass on those almost always since I can typically find better deals in the corporate world or elsewhere. The alternative minimum tax (AMT) status is something else to watch out for, since it can bite some investors and reduce their gains.
Putting it all together
Now you know more about muni investing than the next guy who is going by the Fitch credit rating and what his commission-hungry broker told him. So it's time to wrap up and choose your bond.
The tricky part is that there are no hard and fast rules. After reading the prospectus and assessing all the risks, one must be satisfied with the yield and maturity or not. That's a personal call.
My rule is to never buy bonds for any price above par, no matter how juicy the interest might be. I often screen them based on a maximum price of 90% of par and go down from there. This is because I want to have some upside and plus want to have a margin of safety in the case the bond gets called.
I also don't consider munis if I can get better yield somewhere else, for similar risk profile. Why settle for less? Also, if the yield is so low to be comparable to a CD or a savings or money market account, then why bother?
Next time, I will discuss current opportunities in GO bonds and a few risky issues I found on the dark side of munis.