Municipal Bonds

Municipal Bonds:

Municipal bonds or “Muni’s” as they are sometimes called, are bonds issued by states, counties, cities, or other municipalities.  They are rated by bond rating companies such as Standard and Poor’s and Moody’s just like corporate bonds.  Unless the government changes things (which in this macroeconomic environment is always possible) municipal bonds are free of federal taxes. 

They are subject to state, county, city, and other local taxes under certain circumstances.  For example; if you live in New York City and invest in New York City municipal bonds then you are likely to be subject to New York, state, county, and city taxes on the income your bonds produce.  If you live in any other state other than New York then you are not subject to those taxes.   In short, if you want to buy muni’s you usually should not buy the ones from cities in the state in which you reside. 

They do not pay as much interest as corporate bonds; usually they pay in the 1% to 3% range with between 1% and 2% being most common.  By being tax free you could think of it as a corporate bond that you pay taxes on that pays about 4% is about the same as a municipal bond that you don’t pay taxes on that pays 2%.  Your individual income and tax situation will dictate your actual results this is simply a general rule of thumb or guideline. 

Are they safe?  If you buy the highest rated ones, they are mostly safe, remembering that nothing is absolutely safe.  There are two threats to municipal bonds.  First the issuing municipality could declare bankruptcy in which case you lose all the money you invested in your bond.  It has happened.  Orange County California went bankrupt several years back after their local elected officials invested their funds in very speculative investments that tanked causing the county to go broke and all their bond holders to lose their money. Second, should the federal government change the rules making municipal bonds no longer tax free, then most of the holders of municipal bonds would sell them and take their money to invest elsewhere.  As the price of all investments is controlled by the law of supply and demand, having most holders sell at about the same time would cause the value of the bonds to plummet and huge losses could be realized.  No one knows if the federal government will ever do this but they are discussing it from time to time. 

In general,  municipal bonds are held by investors who have a substantial amount of money and they are looking more for a tax shelter for their investment than to make a ton of loot.  Just think if you make 2 million dollars a year why would you want to risk it?  Rich folks often invest in government and municipal bonds to keep their money safe and in the case of the muni’s,  to avoid paying taxes.  I don’t think that muni’s are a good investment for the small investor, but in the end, it is up to you to do what you wish with your money.

Remember that on average inflation runs around 3% a year so if you are only making between 1% and 2% on your investment you are losing money to inflation every year.  Which is ok if you have millions of dollars but it is not so good if you just have a few hundred thousand or less to last you the rest of your life.  As always contact a certified investment planner who sells nothing but advice before investing.   Remember my writings are simply to educate and not to advise you what to invest in. 

Other than what is stated above, municipal bonds work pretty much like corporate bonds in that they pay out usually every quarter, have a maturity date, are rated by the bond rating services, and some may be callable. As in the case of all types of bonds, they may pay quarterly, semi-annually, or annually.  The main difference is they are federal tax free, pay a lower interest rate, and are backed by local governments and not by companies or the federal government.

Copyright 2012, Greg High, all rights reserved. 

Corporate Bonds

Corporate bonds:

  Corporate bonds are very similar to preferred stocks in that they pay interest to the holder usually on a quarterly basis.  When you buy common stock you actually are buying a piece of that company but when you buy a bond you are actually loaning that company money.  It’s just like when you go to your local bank and borrow money.  In this case you are the bank and you are loaning money to a corporation and in return they will pay you interest payments.  It is very similar to you paying your bank payments on a loan.

 Bonds are rated and there are several rating systems.  The two most famous of the bond rating systems are S&P and Moody’s.    While the rating systems are slightly different, in general a rating of AAA would be the best AAB not quite as good and BBB is the lowest rating that is considered to be an investment grade bond. 

CCC and lower are junk bonds and while they pay very high interest rates, they are not safe.  Why?  The reason is that if the company was stable they could borrow money at a lower rate.  Issuing bonds at a high interest rate is done only as a last resort in most cases and there is a very high danger that companies issuing high yield bonds (also known as junk bonds) will go bankrupt and your bond will be worthless.  If you want to invest in junk bonds only do it in a junk bond fund that way your risk is spread out over thousands of bonds not just one or two and if a few of them go bankrupt you don’t lose everything as you would if you actually bought individual junk bonds. 

Most corporate bonds are not rated AAA, that rating is usually reserved for government backed bonds which corporate bonds are not.  If you chose bonds that are rated BBB and higher then you should be ok but as always there are no guarantees.  Bonds pay an interest rate currently somewhere between 3 and 7 percent with 4-5 being about the norm. 

Just like the preferred stock, as the price of the bond goes up the yield goes down and conversely as the price of the bond goes down the yield goes up.  However if you buy the bonds new and they pay 5% then your yield will always be 5% and it will never change.  Only when the bonds are resold at a higher or lower rate will the yield change. 

The face value of most bonds is $1000.00 when you buy them new.   Oddly enough when you see them listed in the newspaper the new bond would be listed as 100, but it means 1000.  That is a traditional holdover from an earlier time but you should be aware of that factor. 

Most bonds have a maturity date such as if you buy an XYZ company bond that matures in 2025, then in 2025 no matter what the bond has been selling for, it will be redeemed for the $1000.00 face value that you paid for it all those many long years ago.  Bonds can have “call provisions” which simply means if the economy and interest rates change the company has the right to give you your $1000.00 back in full along with any earned interest.  They would do this if interest rates went down and would call in 7% bonds to reissue 5% bonds, for example, as a cost savings for the company. 

There are two types of bonds a regular bond and a debenture.  The regular bond is backed by the assets of the company, so if they go bankrupt they must sell off their assets (forklifts, buildings, furniture, equipment) and give the bond holders some of that money (if there is any left after paying the creditors).  With a debenture you are only going with the full faith and credit of a company’s good name with no assets backing up the bond. 

One probably should not just buy one or two bonds.  If you hold one or two bonds then after one year you would have 50-100 dollars for all your trouble.  That’s not even a good night out on the town anymore.  When considering bond purchases buy 5 or 10 if you can or more and as always, diversify your investments by buying for example, 10 of Company A, 10 of Company B, 10 of Company C, and so on so that your money is invested at least in 3 or 4 different companies and use the bond rating system to help you select the right bonds for you. 

Copyright 2012 , Greg High , all rights reserved.

What is a preferred stock?

Preferred stocks are more like bonds than stocks.  In general, the new price for a share of preferred stock is $25.00 per share.  There are exceptions to this but let us stay with the most common example.  If you buy the preferred shares from the broker at its new issue point then you would pay $25.00 a share.  Every trade after that time is on the secondary market and the price per share is subject to the laws of supply and demand.  The more people that want the stock the higher the price is per share and if fewer people want to own the stock then the price generally goes down.

Every share of preferred stock will have a yield.  For example, one share of XYZ preferred stock sells for $25.00 a share at its new issue and has a yield of  5.0% payable quarterly.  So the yield upon the first day of issue is 5% and you will get a payment of $1.25 per share per year and you will get that payment quarterly at a rate of $0.3125 per share.  (0.3125 times 4 quarters = $1.25)  This is either sent to you in the form of a check or more likely it will be deposited in your brokerage account. 

Let us then say the price of the stock goes up to $27.00 a share after a few months time.  The yield will now show at 4.62 % yield and this applies only to those folks who pay $27.00 per share for the XYZ stock on the secondary market (the name for the stock market after the initial IPO is complete).  Worry not, because you only paid $25.00 a share your yield will never change, you will still get $1.25 per share per year and that will forever be a 5% yield for you.  It is ONLY the person who buys the stock at a different price than the issue price that will get a different yield than you did as the original owner of the shares.

So let’s look at the opposite scenario.  Suppose the price of the stock goes down and not up?  If the price of the stock is now 23.00 a share it will still pay $1.25 per share per year making your new yield 5.43%. 

To review you bought the issue new, then sold the stock to the second owner, who later sold the stock to the third owner.  They all make $1.25 per share per year in interest but the yield changes whenever the price of the stock changes:

You = 1 share at $25.00 per share paying you $1.25 per year interest = 5% yield
2nd owner 1 share at $27.00 per share paying them $1.25 per year interest = 4.62% yield
3rd owner 1 share at $24.00 per share paying them $1.25 per year interest = 5.43% yield

Prices of preferred stocks do not change much but they do go up and down a little most every day.  Also when the stock goes ex-dividend (the date that you must own the stock to get the dividend for that quarter) the price of the stock goes down just a little for a while.  If you buy the stock the day after it goes ex-dividend, then you do not get the interest payment for that quarter (usually just a few days after the ex dividend date). 

Note that preferred stocks pay interest not dividends.  Dividends are paid on some common stocks but not on preferred stocks.  They do use the term ex-dividend for the date described above and that can be confusing but that is what they call it. 

In the overall scope of safety, preferred stocks are safer and less volatile than common stocks and if the company you invested in goes bankrupt the preferred stock holders may get some of their money back before any of the common stock holders are paid.  It is possible for any common stock or preferred stock to go all the way to zero which means you lose all your money.  Nothing is completely safe but FDIC insured CD's or deposits and Government Bonds are generally among the safest investments although they pay little or no interest these days (2012-2013).
Copyright 2012 All rights reserved,  Gregory L. High