Why I Only Purchase Municipal Bonds

Being a millennial, we are typically more aggressive when it comes to investing in the stock market. Typical stock/bond allocation for a millennial can range from 60/40 to 80/20 depending on age and the exposure to risk. I have been closer to the 80/20 mark for a while now ever since I can remember. However, the 20% has always been in Bond ETFs (usually government treasury bonds) which have not generated good returns over time. Currently, iShares Barclays 20+ Year Treasury Bond (TLT) has a 2.67% dividend yield and had a negative performance (-3%) in Year 2018. Usually, the thought process is that a Bond ETF will serve as an hedge against the stock market but that was not necessarily the case last year. Looking at the chart below generated December 21, 2018, the US Aggregate Bond under-performed while the Barclays Municipal Bond did generate a positive return. My issue with those Bond ETFs are not only the performance but the expense ratio that is also charged if you own the ETF.
This led me to spend more time searching for a better Bond alternative. Mid-2018, I switched from Bond ETFs to purchasing new issue Municipal Bonds. Now, my entire 20% is allocated entirely to new issue Muni Bonds. Municipal Bonds are debt instruments issue by a local government. These debts are used to finance public projects such are roads, schools, parks, and other repairs within a city. There are two types of Muni Bonds – General Obligation and Revenue Bonds. The principal and interest for a General Obligation bond is secured by taxing power of the bond issuer while just like the name sounds, a Revenue Bond is secured by revenues derived from the project.
The reason I only purchase newly issued Muni Bonds are the ability to purchase it at no cost, its relative risk, good returns and tax-free nature. Muni Bonds typically generate 5-6.5% in stable income when accounting for the impact of taxation. Taxes can eat into the returns we realize from different investment vehicles. Long term capital gains tax rate is around 15% and short term capital gains are taxed at the ordinary income tax bracket which can vary from 10-37% depending on annual income. The interest earned from Muni Bonds are exempt from taxes boosting the net returns achieved.
Just like other investment vehicles, there is some associated risk and Municipal Bonds are no different. However, Muni Bonds have a relatively lower risk when compared to corporate bonds or the stock market. It is possible to purchase risk-free Muni Bonds that are insured and although, not very common, they do exist and I do own some insured Muni Bonds in my portfolio. Each Municipal Bond has a credit rating that helps assess the amount of risk involved. The Moody ratings range from Aaa bonds (strongest category of creditworthiness) to C bonds (weakest with a relatively higher risk). It makes sense to only purchase Aa and Aaa bonds to minimize risk.
Another aspect to note when purchasing Bonds is the purchase price. The face (or par) value of a bond in the US is typically $1,000 and depending on supply/demand, a bond can be sold at a discount or premium which impacts the yield to maturity. The yield to maturity will be lower than the coupon rate if the Bond is bought at a premium and vice-versa if bought at a discount. It is typically better to purchase at a discount so you can achieve a higher return than the coupon rate. Bonds can also be called by the issuer before it matures so it is very important to focus on the yield to worst as that will be the minimum yield you will realize. It is better to exclusively focus on the yield to worst when compared to the bond’s coupon rate or yield to maturity.
In summary, Municipal Bonds provide a tax-free, relatively low-risk investment vehicle that can generate stable interests for years. Newly issued Muni Bonds can purchased on Fidelity for free and when allocated properly can serve as a hedge to the stock market. There are materials out there that provide more details into how Municipal Bonds are valued and good reads to enhance your knowledge about Muni Bonds.

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