Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 32)

Bonds (part B)

by

Charles Lamson

Municipal Bonds

Municipal bonds is a catchall phrase for bonds issued by state, county, city, or other local authorities. Most people are familiar with "munis," as they are called beecause local governments use them to pay for schools, roads, and other construction projects.

Municipal bonds are rated for the creditworthiness of the issuer. Usually, the issuer needs to show how the bonds will be repaid. The most common way is through existing or increased taxation. The tax money pays the periodic interest rate and builds a pool of money to retire the bonds at maturity.

Munis are exempt from federal income tax and, in some cases, when the purchaser lives in the jurisdiction of the issuer, may be exempt from state and local taxes; the so-called triple tax-free bond. High-income taxpayers are especially attracted to these bonds.

JUST A MINUTE Triple tax-free bonds or mutual bond funds sound great, but only make sense if you are in a fairly high tax bracket. Most middle-income investors will do better in regular funds.

Mutual bond funds that offer the triple tax-exempt status are sold in individual states because the buyer has to reside in that state to qualify for the triple exemption.You can identify these funds in the newspaper tables easily because they often are named for the targeted state.

For example, if you look under mutual funds listings in your Wall Street Journal, you will notice that the USAA Group offers funds titled "CA Bd, NY Bd, and VA Bd." These funds target  muni investments in California, New York, and Virginia, respectively, and are sold to the residents of these states.

Munis are usually issued at a lower coupon or interest rate than corporate bonds with the same rating because of the tax-exempt feature and are sold in denominations of $5,000 and up with maturities ranging from 1 month to 40 years.

Like most bonds, munis usually require a large minimum investment and are sold through brokers. Investment bankers often buy up blocks of the bonds and resell them to dealers and brokers who hold them in inventory to sell to their customers.

PROCEED WITH CAUTION Municipalities guard their bond ratings carefully. A lower rating can mean millions of dollars in extra interest.

While not as safe as U.S. Treasury issues, top-rated munis are considered a minimal risk. Of course, this relative safety and tax-exempt status significantly reduce the interest rate.

Municipal bonds that do not earn a good rating often pay a much higher interest rate to compensate for the higher risk of default. There are a number of mutual funds that specialize in high income from these higher-risk bonds.

Munis, especially those issued with high interest rates, may have a call provision. This provision, which is covered in  the "Prepayment" section later in a later post, allows the issuer to redeem or buy back the bond at certain points in the bond's maturity.

Corporate Bonds

Corporations issue bonds to finance a wide variety of business related needs, from expansion of physical plants to finance acquisitions. Bonds are often preferred over bank loans, because the company may be able to structure the bonds to fit its need at a lower interest rate.

Corporate bonds are rated by the top services based on much the same criteria as munis: creditworthiness, ability to repay, and so on. The bonds are issued at $1,000 par value (that is, full price), but are usually sold in large bundles.

Corporate bonds come in three maturity lengths:

• Short term for 1 to 5 years
• Mid term for 5 to 15 years
• Long term for 15 years+

PROCEED WITH CAUTION Corporations find bonds an attractive way to finance growth and acquisitions. Commercial loans are usually more expensive, and issuing stock may dilute shareholder positions.

Corporate bonds are at the top of the risk scale when compared to U.S. Treasury Bonds, agency bonds, and municipal bonds of the same rating. The reason is that corporations are more vulnerable to the ebbs and flows of the economy, market conditions, and competitions.

Highly rated corporate bonds offer very little risk and are often used in income mutual funds for their stability of income streams. Some corporate bonds have a call feature, so be sure you understand this status before you invest (see the section "Prepayment" in a later post for more information on calling).

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 199-201*

END

JUST A MINUTE

Triple tax-free bonds or mutual bond funds sound great, but only make sense if you are in a fairly high tax bracket. Most middle-income investors will do better in regular funds.

PROCEED WITH CAUTION

Municipalities guard their bond ratings carefully. A lower rating can mean millions of dollars in extra interest.

PROCEED WITH CAUTION

Corporations find bonds an attractive way to finance growth and acquisitions. Commercial loans are usually more expensive, and issuing stock may dilute shareholder positions.