Investors evaluate an insurer's claims-paying ability by the reserves and investments it has for all of its insured customers. This means a company that insures all types of real estate--commercial, industrial and residential--must be able to pay claims to allits divisions. It doesn't mean that if things go horribly wrong in commercial real estate, then residential is out of luck, and the company can still maintain its credit rating.
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Recent insurer downgrades point out what an outright farce we were fed about MBIA (nyse: MBI - news - people ), AMBAC and FGIC. Their AAA ratings should have been withdrawn last year, as their losses from insuring collateralized debt obligations and derivatives descended into an abyss.
The mantra from the New York Insurance Commissioner and Wall Street was, "They must be saved in order to save the municipal bond market." That was the big lie of 2008. Saving the monoline insurers was (and still is) all about saving the banks. Downgrades cause the banks to take additional write-downs. Then the banks have to raise the capital necessary to shore up their pathetically decimated balance sheets.
Thou shalt never buy or sell municipal bonds in the secondary market without using TRACE.
The TRACE system shows recent trading activity in particular bonds. It's a free service accessible on the Web ( www.investinginbonds.com) sponsored by the Securities Investor's Financial Manager's Association. TRACE gives individual investors almost the same pricing information as the brokers. Not only does TRACE list the most recent prices, it also gives a history of the pricing trends.
Using TRACE, individual investors can see the trading pattern of a particular bond in relation to other bonds with a similar credit rating or within the same industry. All these features combined allow individual investors to better gauge their entry and exit points. Not using TRACE when you buy or sell bonds is like trying to drive your car blindfolded--not advisable.
Thou shalt always negotiate prices in the secondary market and never take your broker's first offer as the final gospel.
When buying and selling bonds, your broker is not your friend. As nice a person as they may be, brokers will always place their own best interests before yours. They have no real incentive to give retail clients the best price. They won't see the money again until the bond is called or it matures; that could be years into the future. So they need to make their mark-up for themselves on each transaction right now. Individual investors not using TRACE suffer the results.
Thou shalt always determine liquidity by knowing issue size and maturity size.
We professionals define bond liquidity by the size of the total issue and also by the size of the maturity in which we're interested. Issues too small don't have enough buyers and sellers to make an orderly market. When that happens, prices and availability can swing dramatically. Neither bodes well for individual investors.
Credit quality also has a bearing on an issue's liquidity. Bonds having a high credit quality--high ratings--generally have more liquidity because they fit more investors' risk profiles. With greater liquidity, investors can enter and exit the bond easily.
Thou shalt always consider the taxable equivalent when buying municipal bonds.
Taxable-equivalent yield makes the municipal bond market go 'round. This is the amount of money you would have to earn from a taxable investment like a Certificate of Deposit to be competitive with a tax-free muni. The calculation is easy:
Taxable-equivalent yield = Muni-bond yield / (1 - Federal Marginal Tax Rate)
For example, say we have a yield on a tax-free muni of 4.5%, and the investor's federal tax rate is 35%. The taxable equivalent yield is 6.92% (.045 / (1-0.35) = 6.92%). Said a different way, you would have to earn 6.92% on a CD or a taxable bond to get the same return as a 4.5%. If you can't, buy the bond.
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Thou shalt expect market volatility in leveraged, closed-end municipal bond funds.
Closed-end mutual funds typically borrow using auction-rate preferred stocks. If you're a regular reader of the Forbes Tax-Advantaged Investor, we warned you about the danger of auction-rate preferreds early on. As the subprime chaos affected the credit worthiness of the municipal bond insurers (MBIA, AMBAC, FGIC, et al.), worries grew about the quality of the collateral within the closed-end funds. Investor willingness to hold auction-rate preferreds dried up. Many remain frozen until the fund sponsors can find alternative funding sources. Interest rates on these instruments have soared.
Thou shalt not traffic with the pagan municipal-bond hedge funds, for they are the work of Satan.
The muni hedge funds imploded when the bond insurer's liabilities grew and the credit crisis became acute. As a result, investors who had been enjoying 8% to 10% annual returns from the hedge funds employing an arbitrage strategy using structured municipal-bond trades suddenly found themselves suffering huge losses of principal.
Any thoughts of a positive return dried up when the underlying hedge funds sank to the bottom. Any strategy that depends on a continued imbalance between supply and demand and that assumes a continued difference in the short and long ends of the yield curve will likely have short-lived success--if any.
If thou has less than $200,000 for a municipal bond portfolio, an open-end muni fund shall be your house of worship.
We professionals preach diversification in our clients' bond portfolios. We spread money around a number of issues. We spread money around issues that are insured by the three top bond insurers. We also buy varying types of rated and unrated bonds.
This requires a certain minimum amount of capital to do properly. Our firm, Envision Capital Management, requests a minimum account size of $500,000 in order to sufficiently distribute a client's portfolio. Those individual investors with less than $200,000 can still participate in the muni bond market--we just recommend they do it using an open-end, low-fee muni fund.
Thou shalt follow these 10 Municipal Bond Commandments or face communion with a portfolio of questionable credit quality and mediocre returns.
Excerpted from a Special Report by Marilyn Cohen, editor of Forbes Tax-Advantaged Investor. Click here for more analysis by Marilyn Cohen and to subscribe to Forbes Tax-Advantaged Investor.
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