The Ups and Downs of Investing in Muni Bonds (Municipal Bonds)

• Tweet

• Tweet

Have you ever considered investing in Muni bonds?

Do you know how Mark Cuban, the outspoken owner of the NBA franchise Dallas Mavericks makes his living?

Yes, some of it comes from the revenues the Mavs generate for him, but the bulk comes from his investments in municipal bonds, also called muni bonds in short.

Muni bonds are like any other bond where you act as the bank and lend your money to someone in need. When buying corporate bonds, you are lending to companies. When you buy muni bonds, you are lending to local governments like cities, counties and states.

After selling his start up music company to Yahoo back in the Neanderthal days, Mark Cuban took his cash proceeds and invested it in with the Dallas, Texas government.  His first year’s interest? To the tune of $24 million dollars.  So what does he do? He goes out and buys an airplane on Ebay.

I mean why not? He paid all cash for it.  The benefit of investing in muni bonds is that you are not obligated to pay Federal tax on your interest income and your principal is likely safer with a government entity, or so we think at least?

If you live in one of the, I believe now 7 states that do not tax income (such as Texas where Mark Cuban lives), you don’t pay any tax on your interest – period! Not a bad gig is it? More safety, more money. All sounds hunky dory in Muniland.

Downside of Muni Bonds

Investing in muni bonds have historically been a relatively safe bet. But due to the deteriorating strength of many governments across the country, investors need to take extra precaution when investing in these securities.

Think about what has happened in California and most recently Wisconsin and Illinois. It can be difficult to gain full transparency into a locality’s financial condition, particularly the issues that are yet to surface. There will always be instances going forward where even governments will struggle financially, therefore take extra care when investing in government securities.

Mitigating Risk of Government Insolvency

One way to mitigate your investment risk specifically as it pertains to muni bonds is by investing through a bond fund rather than picking individual bonds.  There are companies that offer muni bond funds that are professionally trained and experienced in researching the financial health of the localities in which they invest.

They are the experts at what they do, so why not let them handle what they are best at? By investing in muni bonds through a bond fund, you will have a full time manager that stays on top of new relevant developments and manages the mix of the fund accordingly.

Given the volatile environment (governments across the world), I would think now is the time to diversify your investments in government bodies to mitigate the risk of total investment loss.

Last year was the first time I invested in muni bonds through Vanguard, who I also have most of my index funds with (small cap, mid cap, SP 500).  When I was researching, I found Vanguard to be the best in this niche so I decided to go with them.

Interest Rate Risk

The other downside I could think of is interest rate risk, which pertains to all bonds in general. Because interest rates in bonds are fixed, you are subject to potential opportunity cost when interest rates rise.  Bond value is inversely proportional to interest rates.  When interest rates rise, the value of your bonds go down.

Why? Let’s say you have a bond that pays 4% on your principal investment and it matures in 2 years. If a bank increases the interest rate it offers on a CD from 2% to 4%, why would you settle for the same 4% return and face risk of default on a bond when your investment is FDIC insured (risk free rate of return) in a bank?

It’s usually not as cut and dry as this, but the point remains.  Do you have any experience with muni bonds or investing with government? How is / was that experience? What do you think about tax free investing in muni bonds and similar instruments?

8 Responses to “The Ups and Downs of Investing in Muni Bonds (Municipal Bonds)”

1. Ukomadu Paul Desmond says:

   September 26, 2011 at 6:03 am

   Simply good.

   Reply
   • Sunil says:

     September 27, 2011 at 3:07 am

     Thanks and welcome Ukomadu

     Reply
2. Evan says:

   October 4, 2011 at 10:22 am

   I don’t have any muni experience. I am first hoping to build my dividend investment portfolio. Once it hits 6 figures (I have a long long time before that happens) I will start to build that income stream.

   Currently, I am afraid of increasing interest rates which will crash bond funds.

   Reply
   • Sunil says:

     October 4, 2011 at 10:53 am

     valid concern on rising rates, but when do you think we will begin to see that? 2, 5, 7 years?

     Reply
3. TomGurney@UKBonds.org says:

   October 13, 2011 at 10:47 am

   I must say that we haven’t covered Municipal Bonds on our own website yet, but it certainly seems like we should do soon, judging by your insightful post. I feel that from our point of view within the UK, most bonds are really good right now, much more secure than certain other investments and with interest rates low right now, they seem a good option. However, things change very quickly, so everyone – always do your research, just like Sunil has done here.

   Reply
   • Sunil says:

     October 13, 2011 at 11:42 am

     Welcome to the blog Tom and thanks for your insights. What are the low risk bonds paying there on average? How does it relate to the risk free interest rate?

     Reply
4. UK Bonds says:

   October 15, 2011 at 10:03 am

   Hi Sunil,

   Here at the moment there are some small banks offering around 3% on normal bank accounts which is actually now worse than short term bonds. Longer bonds at around 5 years and limited access can get around 5%.

   I noticed that you recommend bond funds as a way of reducing risk and i like that idea. Somewhere who is on top of this full time is always going to make better judgements than me, so taking on professional advice seems like a good idea!

   Reply
   • Sunil says:

     October 15, 2011 at 11:19 am

     Tom I am not a professional by any means. I just try to diversify as best as I can slowly and consistently over time.

     Reply