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Misplaced bonds

What if I purchased some bonds and they were misplaced -- could anyone cash them in?
J.K.

Mr. Klotz responds: Most bonds are either in book-entry or registered form and can only be negotiated by the owner.

There are still bearer bonds outstanding which can be a bit problematic. If you lose bearer bonds, be sure to report the loss immediately.
10/26/05

Coupon rate, current yield

I'm new to your site and have found it very educational. What is the difference between the coupon rate and the current yield? Which one determines the amount earned?
A.D.

Mr. Klotz responds: The coupon rate reflects the amount of interest paid annually based on the face amount of the bond (par value).

The current yield is computed by dividing the dollar price into the coupon. Example: A 5% coupon selling at a price of 105.00 has a current yield of 4.76% (5.00 divided by 105 = 4.76).
10/26/05

Santa Rosa Bay Bridge bonds

I bought Santa Rosa Bay Bridge Bonds from FMS a while ago and just noticed on the site that they are listed as "Rev Technical Default. "However, you're still selling them at a premium, and neither the Moody's nor S&P sites indicate any problem. The most recent Moody's rating is from June, the credit outlook is stable and there's no watch. What's up?
J.L., Florida

Dr. Abrams responds: As I'm sure you are aware, the Santa Rosa Bay Bridge has fallen short from its original projections for both ridership and revenues. As a result, the authority was forced to use funds from its debt service reserve to make full payments to bondholders. Under the indenture, this constitutes a "technical" default since debt service coverage tests were below the level required and the debt service reserve was utilized. Investors holding both the insured (which you own) and uninsured bonds have been paid in full and on time. This means there is no "payment" default. Such a payment default would occur if revenues were so low that the debt service reserve was completely drawn down and there were inadequate funds available to pay bondholders the full amount promised. In this instance, insured bondholders would still receive the full amount due them since bond insurance would "kick in" and pay any shortfall.

The rating agencies have Santa Rosa rated below investment grade due to its weak revenue and traffic history. Recently, traffic has increased substantially and revenues have increased at a rapid rate. While some of this increase is due to new construction at the south end of the bridge in combination with better consumer acceptance of the bridge, the state Department of Transportation and other experts believe that a portion of the increase may also be due to reconstruction of I-10 and the widening and reconstruction of a parallel "free" bridge, which has driven traffic to Santa Rosa. We won't know to what extent the traffic increase is due to reconstruction efforts and the inconvenience of the alternative routes until those projects are complete.

In the meantime, estimates of a potential payment default on the uninsured bonds have been pushed out by several years. The rating agencies, while keeping non-investment grade ratings on the bridge, have chosen to keep "stable" outlooks on the Bridge since present traffic and revenue patterns are expected to keep the bridge out of payment default for several years. When the overall trend is better known upon completion of the I-10 and other bridge projects, the rating agencies will likely review Santa Rosa and determine whether the rating should change.

[From J.L. in Florida: Thanks very much for your detailed response. I'd forgotten that the bonds I purchased were insured. I seldom buy bonds below investment grade, but double-checked only the coupon and maturity date before writing you. One of the chief advantages of FMS is that all the bonds have been analyzed by you as well as by Moody's and/or S&P.]
10/14/05

Complete bond forum

Many thanks for the most complete "Bond Investors Forum" I have read in the past 40 years. It is extremely well written and deserving of recognition. I have, on numerous occasions, recommended your firm to newcomers to the bond market as a good source of purchasing bonds and will continue to do so. Wishing you continued success.
B.Z., New York
10/13/05

Rolling over bond fund money to an account with individual bonds

I will be retiring within two years and will have a defined benefit plan retirement of approximately $5,000 per month. In addition, I have another tax-deferred benefit plan, 100% of which is invested in a bond fund, which has been good to me over the last two years, although it has declined in value recently. When I retire, I would like to roll the bond fund over to another tax-deferred account. The balance in the bond fund is approximately $650,000. I also have real estate valued at approximately $800,000 (no mortgages) and cash reserves of $130,000 in CDs. I have been reading the Bond Forum and know how you feel about bond funds. Can I roll over the money in the bond fund to a tax-deferred account owning individual bonds? My lifestyle is such that I don't need additional income to live on.
G.L., Arkansas

Mr. Klotz responds: As you suggest in your email, your tax-deferred account can be "rolled over" into an individual retirement account (IRA).

An account value of $650,000 is more than adequate to provide ample diversification as well as income to fund distribution requirements down the road.

In your IRA, you can own the same individual securities as your mutual fund but forego the additional costs and fees.
10/13/05

State bond banks

Would you please comment on state bond banks and what similarities and differences exist between their offerings and ordinary general obligation municipal bonds?
S.K., Texas

Dr. Abrams responds: Bond banks are state agencies created to provide low-cost financing to small communities that would be forced to pay significantly higher interest rates if they borrowed on their own. At least 12 states have bond banks and each operates differently. The advantage to a community is that ratings on bond bank financings are usually credit enhanced through a moral obligation pledge of the state, a state aid intercept mechanism or a financing structure that allows overcollateralization. None of these "enhancements" are equal to the pledge of a state's general obligation. However, the bonds are typically secured in such a way as to allow a bond rating between that of the state, and the borrower's own credit quality.

Bond banks allow the "pooling" of small loans into one larger bond issue, spreading transactional costs over all participating borrowers in the pool. In some states, bond bank issues may be restricted as to length, size of loan, or project type. The rules governing bond banks vary among the states using them. Generally, the borrowers using the bond bank are smaller and riskier and may not have been able to access the capital markets on their own. Since this is the case, loans need to be reviewed carefully by bond bank staff to insure minimal default possibilities after issuance.

Since bond banks are not usually issued with the direct full faith and credit of a state, they usually carry a bond rating below that of the state. This would especially be the case where the financing is structured based on overcollateralization and doesn't carry the state's credit or moral obligation. Bond banks have been useful tools for certain borrowers and have generally proven to be successful financing mechanisms with a solid track record.
10/12/05

Long ladder

You regularly write against laddering, justifying the position partly by saying that the typical ladder goes out only 10 years. However there is no reason to limit a ladder to 10 years. A ladder can go out 20 or 30 years. If that is done with an initial large sum, then as each group of bonds becomes due, they are replaced with bonds with the most distant maturities. If interest rates stay the same or fall, one will give up some return. However, one will have some protection in case there is a steep rise in interest rates. As we all agree that the future course of interest rates cannot be predicted with any accuracy, a steep rise in rates is a clear possibility. It seems to me that your recommended strategy - putting all funds in the longest maturities - is very risky for investors looking for a safe return. The fact that it would have worked well in the last 10 or 20 years is not meaningful when interest rate cycles tend to be much longer than 10 or 20 years. It is also worth noting that if one had a regular stream of funds (say, every few years) to invest, and followed your strategy of buying only long-term bonds, one would eventually end with a laddered portfolio.
R.A., Illinois

Mr. Klotz responds: We have no quarrel with your suggestion. We are against the traditional 10-year ladder, which sacrifices 40% to 50% of the income available on 20- or 30-year bonds.

We agree that interest rate cycles usually last longer than 20 years. That is why we anticipate this current cycle of lower rates, which began in 1982, to extend much further into the future. Nevertheless, bond investors should not overlook the additional reinvestment dollars available on longer-term securities.
10/10/05

Low-rated bonds and insurance

Why should one be concerned about buying a low-rated bond if it is insured by a quality insurer?
R.W., Florida

Mr. Klotz responds: The only time it might matter would be if there was a default by the issuer and the insurance company did not have the financial ability to meet its obligations to pay principal and interest. This has never occurred primarily because the quality insurers are well funded and have strict criteria regarding issues they insure.
10/9/05

Key is net-after-tax return

I'm 66 and retired. I'm selling my house and will have about $500,000 to $600,000 to invest in a fixed-return investment. I live in Washington with no income tax and was interested in whether you recommend munis over Treasury bills. I'm of course looking for the highest return on my money as I have no other income and don't see being able to reinvest any of the interest.
K.S., Washington

Mr. Klotz responds: The answer to your question is likely to be that you need both.

Investing in taxable Treasuries might push you into a tax bracket that would warrant owning some municipal bonds. The key is to achieve the best "net after tax" return. This would probably mean utilizing a blend of Treasuries and munis in the optimum proportions.
10/6/05

Short-term 'layering'?

I could be wrong, but what about the strategy of short term layering of bonds (two to five years) in a rising interest rate environment? How much would interest rates have to rise over the next few years to counter your view on the disadvantages of laddering?
N.F.


Mr. Klotz responds: This strategy only makes sense to us if you have the ability to accurately predict interest rate movements. The Federal Reserve has been hiking short-term interest rates since June 2004 (rising interest rate environment?).

At that time the 10- and 30-year Treasury bonds were yielding 4.70% and 5.37% respectively. After 11 Fed rate increases, these yields now stand at 4.28% and 4.55%.

As you can see, long-term interest rates have been declining while short rates have been rising. If you implemented your ladder in June 2004, as opposed to buying long-term bonds you will never make up the sacrificed income. This is why laddering is a flawed strategy for income investors. If your objective is 100% liquidity and maintenance of principal, park your funds in a money market.

By the time the Fed is done tightening and short-term interest rates begin to decline, we will likely be looking at much lower long-term rates also.
9/29/05

RANs

If a town issues both rated G.O.s and unrated Revenue Anticipation Notes (RANs), can the same rating be assumed for the unrated RANs?
V.L, Massachusetts


Dr. Abrams responds: In short, the answer is no. The general obligation rating indicates the town has pledged to use all of its resources, including raising ad valorem property taxes, in order to pay debt service. A G.O. bond typically carries the strongest pledge a community can give.

An unrated RAN, on the other hand, can be backed by a particular revenue stream up to the limit of that revenue stream. For example, a sales tax on hotels and meals. In such a case, only the tax proceeds from hotels and meals are pledged, nothing else. RANS are usually issued in anticipation of receiving a specific revenue source and usually must be repaid by the end of the current fiscal year.

In summary, the RAN is normally more limited in the pledge behind it, has a shorter time limit within which the revenues must be collected, and is restricted in ways a GO pledge is not.
9/27/05

When bonds are subject to AMT

You say that a bond subject to AMT should be clearly noted in the description of the bond. I do see that some bonds say "Subject to AMT" in the description and some say "non-taxable." Is there any other type of "tax status"? Does non-taxable mean tax exempt from federal and state taxes (assuming the bond is issued in my home state)? Can you elaborate a little on AMT status? We want to invest some more money in tax-exempt bonds and have begun researching the best way to do that. While we certainly don't need another company to deal with, we are considering consolidating some of these accounts. How are you different from these other companies?
L.B., Missouri


Mr. Klotz responds: The AMT status of a bond is required to be disclosed on the confirmation of purchase. A reputable broker/dealer will also be glad to document the tax status of your bond purchase as it relates to federal and state taxes.

On our Web site "non taxable" means free from federal and state taxes for residents of most issuing states. Bonds labeled "non-taxable" would not be subject to the AMT.

AMT is a required disclosure item and is an integral part of the description of a tax-free bond. This information can be documented through FINRA recognized information services such as Bloomberg or J.J. Kenny.

As far as the Bond Forum, we attempt to respond to our e-mail inquiries as rapidly as possible. We then review the questions and answers to determine which would be the most instructive to other bond investors and reprint these in the Bond Forum. Our goal is to provide practical "how to" information that will enlighten and protect investors when making a bond purchase.

FMSbonds is a FINRA registered broker/dealer specializing in tax-free bonds. Bonds are our only business. If you choose to talk with one of our representatives, you will find he/she to be 100% focused on the bond markets. We provide online account access and are the only firm we know of that provides truly interactive bond purchases, which can only be offered if a firm carries its own inventory. Other companies advertising thousands of bond offerings are essentially offering other dealers' merchandise. Because we own the bonds we sell, we perform our own due diligence on every item we offer, which enables our representatives, who are intimate with the salient features of the bonds, to assist in determining the bonds most suitable to your investment parameters.
9/22/05

Mismanaged accounts

I agree with your philosophy as far as bond management. What is your opinion on advisors who recommend active bond management as a separately managed account to capture gains and losses. They say they get better institutional pricing, which more then makes up for the yearly fee, which is a percentage of assets.
A.C., New Jersey


Mr. Klotz responds: Our opinion has not changed. Actively managing a municipal bond portfolio usually only benefits the manager.

Quality municipal bonds move in tandem as a function of interest rates. Since all bonds move together, buys and sells occur in the same market when a profit is taken on one bond a higher price will be paid for its replacement.

Talk about "institutional" pricing is nonsense. Ask whoever says they will provide bonds at better prices to put this guarantee in writing. These claims will stop.
9/19/05

Who to trust?

It seems that every time I suggest to my broker that he consider some of your Web site information that contradicts his opinion - for example, waiting for interest rate moves and a laddering approach - he dismisses it as being information that is designed to encourage investors to put all their money in a bond program, rather than other alternatives. How do you determine what's best for the average investor?
C.M.

Mr. Klotz responds: Why not make your own observations and trust your common sense? After all, it is you who will ultimately be responsible for your financial security, not your broker.

We have never suggested that investors have 100% of their funds in tax-free bonds, but bonds should be an integral part of every portfolio.

We only claim expertise in tax-free bonds, and in this regard it is indisputable that long- term, tax-free bond buyers whose goal is to maximize income on each purchase have fared considerably better than those who have been persuaded to utilize a 10-year laddered approach.

Your common sense will confirm that since interest rates have been declining or steady for the last 30 years, the short-term, 10-year laddered portfolio that sacrifices
40% to 60% of available income has been a costly strategy.

Your broker's attitude is not uncommon or unfamiliar to us. It is the reason why so many of our clients buy equities and other investment products from various brokerages, but come to us for tax-free bonds. In fact, almost 50% of the bonds we sell are delivered to our clients' accounts held at other firms.
9/9/05

The best of all worlds

Is there such a thing as a fixed-duration, long-term Florida municipal bond fund that would return all capital at the end of the fund life despite intermediate fluctuations in NAV?
B.G., Florida

Mr. Klotz responds: You're describing the perfect income security, and yes, it does exist. It's an individual tax-free bond.

As we've always pointed out, one of the disadvantages of owning a bond fund is it does not have a specific maturity date. If it did, there would be no rationale for the substantial sales charges and ongoing management fees.
9/8/05

Comparing yields

I was told that you need to compare yields to worst case scenario (calls) rather than yields to maturity since bonds are priced to the worst-case scenario. Do you agree? If so, do you then suggest that I buy the highest "worst case" yield instead of the highest yield to maturity?
C.V., California

Mr. Klotz responds: It makes sense to look at both. As a premium bond investor, I want to buy bonds that yield 25 to 50 basis points more to the call (WCY) than the yield I can buy on a new issue bond, of comparable quality, maturing in that year.

The yield to maturity should also exceed the new issue yield to maturity.

Regarding what you refer to as "higher yields on smaller coupon bonds": appreciation on discount bonds is subject to capital gains tax. This should be reflected in the yield-to-maturity.
9/7/05

Bond Basics

If I buy a bond, can I sell it before its maturity date? Will I lose any money? If a bond has a coupon rate of 6.125% and WCY of 3.64%, how much interest will I earn?
A.B., Connecticut

Mr. Klotz responds: Bonds are liquid investments that can be sold any time prior to maturity, without penalty. The price you receive will be based on market conditions at the time of sale.

"Coupon" refers to the fixed rate the bond pays annually until it matures. On a $100,000 investment, you would earn $6,125.00 per year. "WCY" stands for worst-case yield. This is the yield you would receive if the bond was called by the issuer prior to maturity.
9/7/05

Waiting for Greenspan

I wanted to invest my money after Greenspan spoke recently, expecting to invest at higher rates since everyone expected the Fed to raise rates. What's going on? Why are rates not rising? The long end of the muni curve was higher yielding before Greenspan spoke. The short end of the curve is also lower yielding before Greenspan spoke. Should I continue to wait knowing that the Fed will continue to raise rates in the future? Is this rally in the market just a fluke?
C.V., California



Mr. Klotz responds: Actually, long-term bond rates are lower today than they were when the Fed began its series of short-term rate hikes in June 2004. The reasoning is the Fed, by raising short-term rates, will keep inflation in check. Inflation concerns cause long-term yields to rise.
8/12/05

Simple, or not

AYou state in the article "ETMs and You," , "The concept is simple: when buying ETM bonds, investors should be certain that all calls have been defeased or the bonds have been priced to the call date." While that may be simple to you, it's not that simple for individual bond investors to ascertain that an ETM bond's calls have been defeased and the bonds have been priced to the first valid call. How many investors know where to find this information? If an ETM bond's description doesn't state anything, are we to assume that its calls have not been defeased and it is not priced to its first call, or are we to assume the opposite? Two simple categories in your bond descriptions would alleviate this concern for investors: "This bond's calls have been defeased: yes or no," and "This bond is subject to call before the ETM maturity date: yes or no under no circumstances." With these two descriptive categories and a mandatory "yes or no," much confusion and suspicion would be eliminated. Now it appears that the investor is subtly being told, "Let the buyer beware," which not only alienates the investor but probably deters future investment. One municipal dealer I used to deal with actually had a category, "callable." However, there were instances that when it said "no", the "no" wasn't really a "no." There were extraordinary call provisions that would make that "no" a "yes" and the investor didn't find out about it until it was called.
J.M., Illinois


Mr. Klotz responds: We agree the investors should not be forced to obtain this information themselves. It should be provided by the brokerage firm offering the bonds and the call status should be noted on the confirmation of sale. Unfortunately, there are too many firms selling bonds that may not be aware of all the nuances of escrowed securities, thus our caveat.

There are two ETM offerings on our site today that illustrate this point. The Intermountain Power Agency 5% due 2012 bonds are escrowed to maturity but are callable prior to maturity. As you can see, they are priced to reflect this call. The North Carolina 5 1/2% bonds due 2014 listed below them are not callable prior to maturity. This is reflected on the bond detail screen, which is accessed by clicking on the bond offering. These bonds are priced to maturity.

It is the responsibility of the brokerage firm, not the issuer, to be as clear as possible regarding the call status of escrowed bonds. Most brokerage firms have this information available to them through information services such as Bloomberg or J.J. Kenny. Our advice: if you don't see it in the description, ask.
8/01/05

Trying to avoid laddering

I will soon have a large amount of money that I'm going to invest in bonds and was considering laddering. Even though your articles make sense, what if I invested all the funds into a long-term bond when interest rates were at their lowest?
S.S., Florida


Mr. Klotz responds: Interest rates are cyclical. By maximizing your income you will be able to weather a period of higher rates (which is always followed by lower rates). Most laddering strategies, with the longest maturity being 10 years, sacrifice 25% to 40% of the income available on longer-term bonds.

Timing the interest rate markets can be treacherous. Investors who have employed this laddering strategy over the last 20 years have continually been forced to reinvest their maturing bonds at lower rates.

The additional income produced by long-term bonds allows reinvestment at the higher rates if they do come about.
7/29/05

Early redemption

AFirst, I want to say that I thoroughly enjoy your columns. My question is concerning Early Redemption. As I understand it, most bonds are subject to early redemption. It seems that ER makes the yields completely unpredictable, as the bond issuer may redeem (call?) the bonds at any time regardless of the call features. Can you please comment?
M.M., Ohio

Mr. Klotz responds: Most municipal bonds carry an "extraordinary" or "catastrophic" redemption feature, but are rarely exercised. These calls usually are exercised in the event of catastrophic circumstances causing the funded projects to be cancelled. The parameters for this type of call are outlined in the official statement.
7/29/05

The IRS and capital loss

I have been a retail broker for 18 years and I really enjoy your site. It's straightforward, concise and results-oriented. Thanks for your work. I was reading your Q&A and noted with interest (hah!) the question about declaring a capital loss when a bond bought at a premium is called or comes due at a lower price. My reading of the tax law agrees with yours, which is to say that you cannot claim the loss. What is interesting to me is that every CPA that I deal with claims the loss! I have a large bond client who reads OS's cover to cover. He spoke with three different folks at the IRS and all three of them told him that it was OK to take the loss. Once again de facto and de jure go head to head and de facto wins! I also remember starting my career in 1987 and 1988 with 8% insured Metropolitan Washington Airport bonds. Back then, people declined. My how things change.
S.G., Virginia

Calling bonds at a premium price

A bond broker told me that if an issuer does not call a bond at a premium, say 103, and waits to call the bond at par, the issuer must still pay 103 to the bondholder. This doesn't sound logical. Did I misunderstand him?
J.F., California

Mr. Klotz responds: As you concluded, this is not only illogical, it is inaccurate. Optional "call features" on municipal bonds usually offer a premium initially and systematically decline to 100.00. Theoretically, if the bond is not called at a premium price, the bondholder is compensated by keeping the bond for a longer period of time.
7/25/05

Fully insured bonds

Would you please explain to me what a fully insured bond is?
D.G.

Mr. Klotz responds: Municipal bond insurers guarantee the timely payment of principal and interest on a tax-free bond. The insurance provides an additional layer of security to the bondholder. In the unlikely case of default by the issuer, the insurer has the option to continue payments on the original schedule or pay the full "face value" to the bondholder immediately.
7/20/05

Investing and your state of residence

I'm 35 and currently a California resident. If I buy really long-term California municipals with the intention of holding them until they mature, am I constraining myself for the tax benefits to remain a California resident for the long term? It's too soon for me to know where I'll want to live in five years, much less 30. If and when I move elsewhere, I could sell the California bonds and replace them with bonds from my new resident state, but that would involve transaction costs. Also, it would undermine the buy-and-hold strategy and put me at risk of selling at a discount. Are municipal bonds best as an investment for people who know that where they live is where they'll always be? Thanks for a very informative site with well-reasoned and persuasive advice.
S.O., California


Mr. Klotz responds: We fear you are unduly concerned with the constraints of changing your state of residence.

Because California has one of the highest state tax rates in the country, "swapping" into bonds issued by most other states is easily accomplished.

Since the sale of your California bonds and the purchase of new bonds would be executed under the same market conditions, any discounting of your holdings would also be reflected in the new bonds purchased. (Transaction costs should not be prohibitive.)
7/13/05

On " 'Common Sense' Column Defies It"

Mr. Stewart may be wrong, but you don't have a crystal ball, either. Bottom line: Mr. Stewart has no ax to grind. You, on the other hand, want to sell bonds now.
M.L., North Carolina


Mr. Klotz responds: This was precisely our point. Since no one has a crystal ball, attempting to time interest rate markets is the antithesis of "common sense." Our quarrel with Mr. Stewart's column is not with his forecast, but with the fact that he is forecasting. "Ax to grind" or not, over the past 30 years, bond investors who bought long-term bonds when their funds were available - and did not attempt to guess the direction of interest rates - are very pleased they did.
6/27/05

Non-callable bonds in worst-case scenario

I own a number of long-term PA zero-coupon muni revenue bonds. All of the bonds are AAA insured -- many are also ETM -- and they reflect revenue from water and/or sewer systems. All of the bonds were listed as "non-callable" when I purchased them, with no conditions attached whatsoever. If the worst were to happen to one or more of the water/sewer systems whose bonds I hold (e.g., large-scale destruction or significant long-term disruption due to terrorism, major earthquake, etc.), can these bonds be called (i.e., paid off at less than par prior to maturity) even though they were listed as "non-callable" when I purchased them? Or would I still be able to count on the $1,000 per bond value at the original maturity date of the bonds? I have received much conflicting advice on this from different brokers.
A.B., Pennsylvania


Jay Abrams, Chief Municipal Credit Analyst, FMSbonds, Inc. responds: The bonds you asked about may both be rated "AAA" but they are secured differently. Bonds that have been escrowed to maturity (ETM) typically have been refunded by a new bond issue. The proceeds of the new issue are invested in U.S. Treasury securities and held in an account restricted in use for the payment of the original bond issue on its interest and principal due dates. Such bonds are no longer the responsibility of the original issuer, no longer appear on its balance sheet and are considered "defeased." In such a case, the relationship between the fortunes of the original issuer and the payment of the original bonds ceases to exist. Bondholders are solely secured by the Treasuries held in the escrow account by the bond trustee. It is important when buying such bonds to make sure they have been re-rated by a major rating agency who looks to ensure that the defeasance has actually occurred and that the cash flows will be adequate to pay the bonds when due. Some escrowed issues are not re-rated by a rating agency and the purchaser of such bonds will need to check the documents on his/her own.

In the case of bonds rated "AAA" resulting from the purchase of bond insurance, the insurance policy actually represents a second level of security that is invoked in case the issuer fails to make bond payments from its own sources. In such a case, the bond insurer steps up to the plate and makes the payment. Such policies are noncancellable. In the case of a bond default, the insurer has the option to continue payments on the maturity schedule, or pay bondholders the face value due to them at maturity. If the bond is a zero coupon, the accreted value would be paid. This would result in the bond being retired prior to its original maturity date.

In either case, both ETMs and "AAA" insured bonds are considered among the most secure municipal securities available.
6/27/05

Yield-to-call on secondary market vs. new issues

I am retired and 75 years old. I rely on a large portfolio of municipal bonds and income from my deferred income accounts to maintain my style of living. I hold the bonds to maturity or call and never pay attention to price fluctuations. I buy only high-grade bonds, 100 bonds at a time, (Aa1 or AA+ or better) and only pay attention to coupons that will maintain my income. I buy bonds where the yield-to-call is close to yield on new issues due on the call date. This always means premium bonds. I now find that to get coupons of 4% or 5%, I pay a higher premium price. Since these bonds mature in 15 to 25 years, and I have older bonds with higher coupons, and I have cash equivalents and constant withdrawals from my IRAs, I have no difficulty maintaining the desired income level with minimal change in my net worth. I would be much interested in your opinion of this strategy. Following your lead I avoid laddering.
R.Z., Florida


Mr. Klotz responds: We are in complete agreement with your portfolio strategy. Our only question is in regard to your comment comparing yield-to-call on secondary market items to new issue bonds maturing in the same year. The yield-to-call on secondary market items should exceed the yield to maturity of a new issue maturing the same year.
6/22/05

Watching the watchers

Given the past scandals involving brokerage houses and their former star analysts who were found not to have the best interests of investors at heart, how confident are you that the municipal bond insurance companies are themselves completely above board, and when the inevitable financial debacle hits the muni bond investor, that these insurance companies won't rely on the SODDIT defense (some other dude did it)? Put another way, who is watching those who insure the municipal bond investor against default and how can an investor be confident in the financial stability of these companies?
L.C., New York


Jay Abrams, Chief Municipal Credit Analyst, FMSbonds, Inc. responds: While recent scandals on Wall Street have raised the eyebrows of investors everywhere, it is important to realize a number of facts. The brokerage houses and star analysts you allude to were on the equity side of the business, not fixed income. Unlike equities, analysts in the fixed-income markets have far less ability to impact market forces. Unlike in the equity markets, rating agencies tend to have a much greater influence on pricing than individual brokerage house analysts.

Your concern that there will be an "inevitable" financial debacle in the municipal market is difficult to substantiate. Remember, municipal bonds are used to finance capital improvements needed by states, cities, hospitals and other essential public functions. They are not issued by companies whose products may have limited "shelf life," or based on a business plan unlikely to succeed. As a result, the default history in the municipal market is very small.

You also indicate unease with the headlines that have run recently regarding certain business practices of MBIA, the municipal bond insurer. However, the practices in question affect only a small portion of MBIA's overall business. All three major rating agencies (S&P, Moody's and Fitch) continually monitor the bond insurers for both adequacy of capital and credit quality of their insured portfolios. In fact, S&P released its annual review of MBIA last week (affirming its AAA rating) and noted that MBIA's "management has a long history of maintaining a strong capital position to support business growth as it has expanded its underwriting." It is also true that most of MBIA's and other insurers' credit portfolios enjoy underlying investment grade ratings on their own.

Finally, MBIA and other insurers are also reviewed by state regulatory bodies, investors, and others with a direct interest in the bond insurance industry. You can visit the Web sites of these companies and read their financial statements, SEC filings and other pertinent information to help you develop a comfort level with their operation and safety.
6/21/05

Maturities and effective taxable rate?

I am an FMS client and am happy with our relationship. Three questions: First: Since I obtain most of my income from municipal bonds, I end up in a low tax bracket. For example, my portfolio has an average yield of 5%. Suppose I'm in the 20% tax bracket. Therefore, my taxable bond equivalent, as I understand it, is 6.25%. If I were, instead, to be invested in taxable paper, would my tax bracket go up? Second: If I buy a 15-year bond at 103, keep it to maturity and redeem it at par, I may not deduct the difference as a long-term loss, correct? Effectively, the taxing authorities are saying that the premium simply affected the yield. Is that right? My third question is the other side of the same coin: If I buy a 15-year bond at 97 and keep it to maturity, do I pick up the difference as a capital gain? Effectively, then, the taxing authority is saying that the discount on the bond is not simply affecting the yield. If my assumptions are correct, then they are really having their cake and eating it, too. OK, while we're discussing fairness, let me slip in a fourth question: Bond issuers often specify call dates. I guess that's fair since we buyers go into a particular issue with our eyes open. (Why don't we band together and tell the issuers that we want certain give-back dates at specified prices?) But, what about those "extraordinary" call provisions? How can we guard against those?
M.P., Florida

Mr. Klotz responds: Your questions reflect an excellent understanding of municipal bonds and the related tax implications.

You are correct in thinking that your municipal bonds would provide a higher taxable equivalent yield if you were to increase your taxable income by adding some taxable bonds to your portfolio. Keep in mind, however, that you will be trying to hit a moving target that will be affected by the trading relationship of the taxable and tax-free markets. When comparing offerings, calculate the after-tax yield on the taxable bond to be sure it nets more than the municipal. (In your bracket you will net 80% of the taxable bond yield.) As you start to add taxable bonds to the mix, you must also keep an eye on your tax bracket, which will creep up and alter the equation. You must adjust your calculations accordingly.

You answered your own questions accurately regarding the tax treatment of premium and discount bonds. The IRS does not allow the investor to declare a capital loss on premium bonds that mature at 100. But there is a capital gains tax due on the appreciation of a bond purchased at a discount.

Almost all revenue bonds are issued with some sort of "catastrophic," "condemnation" or "extraordinary" call provision, but these calls are rarely exercised and the criteria are fairly stringent.

Take solace in the fact that bond investors have influenced issuers and underwriters over the years by resisting issues that provide little or no call protection. This is why 10 years has become the standard provision.
6/17/05

Maturing zero coupon bonds

You received an e-mail from "P.W." on 2/9/05 regarding the need to report a maturing tax- free zero coupon bond to the IRS. The 1040 schedule in which capital gains are reported asks for purchase and selling prices of a security. How should the tax filer make clear that the bond was a tax-free muni zero and, therefore, no tax is due even though there was a difference between the purchase and selling prices? Also, in your response to P.W., you stated, "Based on the original cost, munis can be subject to capital gains." Can a tax-free zero muni be subject to capital gains? If so, how would this be calculated?
J.F.

Mr. Klotz responds: If your zero coupon bond was purchased at the time of issuance, the tax-free interest earned on the zero coupon municipal bond acts to increase your cost basis in the security. Your adjusted cost at maturity would then be equal to the redemption price, which indicates no tax is due.

If the zero coupon bond is purchased after issuance, below its accreted value, the difference between the adjusted cost basis and the redemption price could be subject to capital gains tax.

Please consult your tax advisor for a definitive answer regarding your specific situation.
6/13/05

Bond ratings

Assuming an unrated municipal bond has the equivalent credit quality of, say a BBB rated municipal bond, what is the typical or average increase in basis points for being unrated, also assuming same maturity?
P.K. Colorado

Mr. Klotz responds: Although bond ratings can be helpful in providing general guidelines to investors, they are not the last word in determining how a bond will be valued in the marketplace. Assuming all other factors are equal (coupon, maturity, location, etc), all BBB bonds will not necessarily trade similarly.

Certain non-rated bonds can command a higher price than rated bonds based on market participants' perception of underlying credit quality.

There are also instances when issuers chose not to apply for a rating to avoid the fees charged by the rating agencies.
6/10/05

Forecasting in a fog

I thought you might be interested in a Bloomberg article, "U.S. Bond Forecasters, Wrong on Yields in 2004, Blow It Again." The best thing about this article is that these guys take no responsibility for their bad calls. They say that they will be proven right. Most of them have called for higher rates since Oct. 31, 2001, by telling people to stay short. They have cost investors billions of dollars. They just don't get it.
B.N., West Virginia



Mr. Klotz responds: I did see the article and your point is well taken: Individual investors who followed these prognostications and stayed on the sidelines suffered. And yes, the soothsayers spout their predictions with impunity. It is sad and costly.

But not everyone stayed on the sidelines for the past four years. At FMSbonds, we have assisted thousands of new investors, enabling them to take advantage of longer-term bonds and maximize their income and reinvestable cash flow.

As we have pointed out many times over the past four years, there is indeed a cost of waiting. It is simply impossible to time the market and extremely unwise to try. And if there is any question as to the reliability of these forecasts, the comment by one oracle - that he's comfortable using a dartboard to come up with his forecasts - should put those doubts to rest.

I continue to urge parents to encourage their children to become economists, which is the only profession in which they can be paid handsomely without having to be right.

(As a side note: I no longer receive nasty e-mails questioning my intelligence for not recommending laddering or remaining in cash until interest rates rise. But alas, that reprieve may be temporary.)
5/23/05

Rate hikes?

At the start of Greenspan's interest rate hikes, when the masses were calling for higher interest rates on bond yields, you were right when you stated that you would not be surprised if yields peaked. Now that it seems that the masses are lowering their yield expectations, I'm curious to know whether you think we might see higher rates again.
A.C., New Jersey


Mr. Klotz responds: Right now we don't see anything on the horizon to make us expect higher long-term interest rates. However, we are a bit uncomfortable, with all the recent company.
5/20/05

Investing idle cash

I was very pleased to stumble across your Web site and find a firm that supports my investment strategy. I therefore trust your answers to some questions that I have (and believe me, that says a lot). My family has invested in municipal bonds for generations and I have followed suit. I am currently managing my portfolio exactly as my father and grandfather do, but I have some questions that I would like you to answer because their answers are simply that it's "the way we've always done it."

First, I only buy long-term premium munis for the highest Yield to Call/Yield to Maturity that I can find, exactly as you suggest. I normally wait for the interest to build to a certain amount before I buy another bond. I do this because I can get a better price by buying a bigger chunk of bonds. It takes a few months to get to this point, and I sit on the cash in the meantime. (It's actually in a type of money-market account.) If I don't need all of the income to live off of, how would you suggest investing it until I have enough to buy another bond?

Second, I currently live in Washington, D.C., where my munis from all over the country are triple exempt. If I decide to move to New York for a few years with the intention of returning to D.C., what would you recommend doing? I obviously don't want to liquidate my holdings and reinvest them in N.Y. bonds because, for one, I would get hosed on the bid/ask spread. Should I just weather the few years and pay the state and local tax? Third and finally, when a muni is pre-refunded, do you recommend selling it?
T.B., Washington, D.C.

Mr. Klotz responds: Thank you for the kind words. It is always nice to hear from someone who has employed this strategy over the years, since you have experienced, first hand, how successful it has proven to be.

As a buy-and-hold investor you may want to investigate purchasing "odd lots" with the additional income accruing from your portfolio. These smaller blocks should actually be cheaper, unless you are buying a small piece of a larger block of bonds. We don't recommend this when resale is a consideration.

You have probably answered your own question when it comes to your temporary relocation to New York (although you might want to look into the possibility of retaining your Washington D.C. domicile during this period). You are correct in thinking that transaction costs could prove more onerous than paying the New York tax.

We recommend selling pre-refunded bonds if the value of the bonds increases to such an extent that the "new" yield on these securities (return per dollar invested) becomes prohibitive. Although you will probably be unable to match the income, you should be able to have more principal working at a much higher yield. This opportunity is most prevalent when the pre-refunded date is at least four or more years away.
5/19/05

Hazy about tobacco bonds

I saw an ad about your site in Sunday's paper. Just went online to investigate it but was turned off on your story about "good news for the tobacco investor." You guys completely turned me off with it seems support for the tobacco industry. I can find investments many other places and will skip your site.
G.R., New York



Mr. Klotz responds: We think you are confused about the nature of tobacco bonds. Here's a little background that might clarify things for you.

In 1998, an agreement was signed between the four largest tobacco companies and 50 states and territories. The accord, known as the Master Settlement Agreement, requires the original tobacco companies, plus 36 companies that signed afterward, to pay approximately $206 billion over 25 years to the states as repayment for health costs borne by the states from smoking-related illnesses. The states, in return, agreed not to sue tobacco companies who are part of the agreement.

Many states - including New York - sought immediate access to their portion of the settlement funds and chose to securitize them using the tax-free bond market. Incidentally, New York has issued more than $2.5 billion of these bonds.

These bonds have proved to be popular among investors. In fact, the states combined have issued approximately $20 billion of these securities, the majority of which are owned by individual investors.

As a municipal bond dealer, our job is to provide important information to municipal bond holders regarding the status of their investments. That's what we're doing when we report on news that might affect the bonds. (Judging by the volume of correspondence we receive, many investors appreciate it.)

Our news is not directed to people who own stock in tobacco companies, as your e-mail suggests, but to holders of the tobacco settlement bonds issued by states.

Tobacco bonds are the result of tobacco makers being punished, not rewarded. An investment in tobacco bonds does not support the tobacco industry. It simply ensures that states get their money sooner rather than later. (As it turns out, many states now depend on funds from the tobacco settlement.)

In regard to your comment about seeking investments elsewhere: We hope you choose to do business with us, but if not, it may be impossible to find a firm that doesn't sell or report on tobacco bonds (or, for that matter, firms that don't sell or report on the stock of tobacco companies).

For more on tobacco bonds, visit our Commentary and Analysts' Insight pages or scroll down on this page.
5/19/05

Capital Appreciation Bonds

I am in a bit of a quandary. I am attempting to find specific information on CABs (Capital Appreciation Bonds), such as how they work exactly and the relation to a refinanced structured loans. If you could provide any reference material or point me in the right direction I would greatly appreciate it.
J.A., New York


Jay Abrams, Chief Municipal Credit Analyst, FMSbonds, Inc. responds: The Municipal Securities Rulemaking Board (MSRB) defines a Capital Appreciation Bond:

A municipal security on which the investment return on an initial principal amount is reinvested at a stated compounded rate until maturity, at which time the investor receives a single payment (the "maturity value") representing both the initial principal amount and the total investment return. CABs typically are sold at a deeply discounted price with maturity values in multiples of $5,000. CABs are distinct from traditional zero coupon bonds because the investment return is considered to be in the form of compounded interest rather than accreted original issue discount. For this reason only the initial principal amount of a CAB would be counted against a municipal issuer's statutory debt limit, rather than the total par value, as in the case of a traditional zero coupon bond.

I am not aware of any particular relationship to a "refinanced structured loan" that you refer to. CABS are frequently issued for both new capital project purposes as well as refunding issues.

For further information, you may wish to visit the MSRB's Web site (www.msrb.org) or contact the Public Finance Department of either a regional or national investment banking firm. Such firms have great experience in structuring bond issues and are well versed in the benefits of different bond maturity schedules and related concepts.
5/17/05

Don't forget state income taxes when determining taxable equivalents.

In K.B.'s inquiry of 2/09/05 (see below, "Taxable equivalent") pertaining to computing equivalent returns on taxable vs non-taxable bonds, you referred to a chart entitled "Tax-exempt/Taxable Yield Equivalents" in the Bond Basics section of your Web site. The problem is, it doesn't give the complete picture on equivalents. It pertains to federal tax only and therefore is applicable only to those few states with no state income tax. Most people reside in states that have state income taxes and, obviously, this tax must be considered when computing equivalents between taxable and non-taxable instruments. In California, where I reside, the maximum income tax rate is 9.3% - a substantial amount. To determine if a state tax-exempt bond or bond fund is appropriate, one must compute the tax-exempt bond or bond fund's "taxable equivalent yield." This figure enables one to take federal and state income taxes into account when comparing the potential returns from taxable and non-taxable instruments. For completeness, I believe it should be mentioned when questions arise relating to equivalents between tax exempt and taxable instruments.
C.A., California

Mr. Klotz responds: Your point is well taken. Veteran bond investors residing in California and other states with significant state taxes are usually aware of the need to avoid "out of state" issues (other than U.S. territories). Newcomers to the market should be made aware of the potential impact when venturing across state lines. We will be sure to add this addendum to any future discussion of this topic.
5/3/05

Finding pre-refunded bonds

I am interested in municipal bonds that are pre-refunded and collateralized in U.S. securities. The maturity can go way out, as I want high interest. Why do you rate some of the municipal bonds insured by MBIA as AAA? Do you think MBIA could weather two or three bankruptcies in municipal bonds? I think it's doubtful. I consider insurance on municipal bonds valueless. Are you a member of CIPA or SIPC?
D.J

Mr. Klotz responds: The ratings we display on our Web site are assigned by Standard & Poors Corp. and Moody's Investor's Service. FMSbonds is a bond dealer, not a rating agency.

Based on the required reserve structure of bond insurers, such as MBIA, we are confident that MBIA could easily weather multiple defaults on issues it insures.

Yes, we are a member of SIPC.

Pre-refunded bonds carry shorter maturities because tax-free bonds are typically refinanced and escrowed to their call dates. You will find a number of these offerings on our Web site designated by a "pre" on the left of the YTM column.
5/2/05

Are high yields and early call dates linked?

I have been investing in municipal bonds for the last three to four years simply because they provided a reasonable rate of return relative to risk. I have noticed that the high yields and early call dates are related. What I mean is, when the rates (yields) are at historic highs, the issuer usually puts in a call date at five to 10 years on a 30-year bond. So there is no point in waiting to time the market (assuming you can do it) because you can't really lock in the rate for 30 years. If rates do fall five to 10 years from the issue date, the issuer can call. I observed this on the following basis. If rates now (about 4.5%) are low compared to historic highs (10 to 12%), then I do not see any bonds available today with a coupon of 10 to 12% at a high price to compensate for today's relative lower rate. Given this, there is no reason to wait to lock in a rate even if there is a fairly general consensus that rates will go up in the next year. In your long experience, have you seen bonds issued at high rates (10%) comparable to long-term S&P average rates without call features? Did anyone get lucky?
K.K.

Mr. Klotz responds: Although your observations may be correct, we think your conclusion may not be. Most new bonds are still being issued with 10-year call dates. The higher coupon bonds you refer to were issued when interest rates were higher and had a 10-year call feature at that time (ex. callable 5/1/09 at 102.00). Today the bond is callable in four years because of the time that has elapsed since its issuance.

The state of California still has some non-callable outstanding debt carrying interest rates of 10%. Most of these issues are nearing their final maturity dates.
4/29/05

Buying registered bonds

I have one primary requirement before purchasing a bond: I must have the certificate mailed to me after the purchase. I understand that it's inconvenient when selling the bond, but that is not a concern. I do not actively trade in the bond market; rather, I keep the bonds to maturity or the call date. Do you provide this service, and if so, what is your charge to register the bonds in my name and have the interest payments sent to me directly through the paying agent?
J.M.

Mr. Klotz responds: Although most bonds are issued today in book entry form, there are still some registered bonds available in the market. If bonds are "registerable," we would be pleased to register them in your name, have the certificates mailed to you and you will receive your interest payments directly from the paying agent. There is no charge for this service.
4/27/05

Calling ETMs

Your article (ETMs and You) hits the ETM issue right on point, but there is one item that still is rather perplexing: In the case of the New York City escrowed bonds or any other ETMs with call provisions, why would the bonds be called? I understand that any "profit" from the underlying Treasury price appreciation is kept by the IRS, so financial motivation seems to be ruled out, unless there's some nominal administrative expense associated with keeping the bonds outstanding. Could this be it or is it something else?
J.M., Michigan

Mr. Klotz responds: The IRS has prohibited municipal bond issuers from profiting from the arbitrage created by the spread between taxable and tax-free interest rates. However, issuers can still reap the rewards of price appreciation of the escrowed Treasury securities (after taxes).
4/22/05

Muni bonds for school improvements

My county wants to issue $60 million in bonds for capital improvements to our school system. Many question the advisability of using bonds vs. some other form of ad valorem tax or use of a lottery or sales tax. I think alternatives to the bond issue might, in the long run, be more expensive and less suitable to the intended purpose. The bond issue seems to be advantageous in that it obtains the money up front and is, in effect, a sunset law that expires on the maturity date. As we all know, taxes go on forever, even after the original purpose has ceased to exist. Further, the cost to the taxpayer will be less with a bond issue than with any other means of obtaining funding. Assuming a 30-year issue with a base interest rate of 4.5%, the county would need to raise about $2.7 million annually for interest payments and create a sinking fund of under $2 million to cover payments at or before maturity. These funds could likely be obtained by some form of property transfer tax, so future residents would be assuming a fair share of the school expense burden. Am I off the wall? Is there a better way to raise this money? If bonds are the way to go, what interest rate and term should be expected? D.C.

Mr. Klotz responds: We don't think you are off the wall.

The traditional method for funding public school improvements is through the municipal bond market.

The bonds are typically General Obligations of the issuing municipality, secured by property taxes.

As you suggested, the debt service is usually structured in serial form (bonds would be retired each year), extending over the life of the facility. The quality of the issue would be based on the assessed valuation of the county and its history of tax collections. The expected interest rate would depend on the schedule of redemption and the credit quality of the issuer.
4/19/05

MBIA and investor comfort

Like many other Americans, I am growing weary of corruption and fraud in major companies. The most recent company facing serious allegations of misconduct is MBIA (Rating Agencies Say MBIA Still Solid), no small player in the municipal bond market. Is this the tip of an iceberg? Are the bond insurance companies so eager to issue and so closely tied to the ratings agencies that they are getting reckless? It seems to me that most municipal bonds are now insured, clearly suggesting to a trusting public that there is little risk of default. Some of these insurers have been in business for only a relatively short time and have hundreds of billions of dollars in guarantees out there. Where can investors get information on the underlying credit ratings of muni bonds? Most brokers and dealers show only AAA when the bond is insured. False comfort?
J.P.

Jay Abrams, Chief Municipal Credit Analyst, FMSbonds, Inc., responds: While we don't know the outcome of investigations into MBIA's management practices, we do know they have an extremely strong capital base supporting the insurance contracts they have written. In addition, MBIA mainly insures large visibility credits in the tax-exempt market, which normally have strong investment grade credit quality on their own. The same is true for other bond insurers.

In many cases, underlying credit ratings can be obtained directly from the rating agencies themselves. However, in-depth analyses usually require an expensive subscription. You might try the Web sites for S&P, Moody's and Fitch to see which bonds you own have public ratings.

Finally, we are confident in the level of review all three rating agencies conduct on the bond insurers on an ongoing basis. Both the transactions and capital adequacy of bond insurers are reviewed continually and must meet target levels to maintain their ratings. It is a rare occurrence for a bond insurer to fall short on these measures.
4/18/05

Using funds in a qualified plan to buy muni bonds

My husband and I are looking into investing in bonds to generate an income stream so we can build a retirement home and use the money to pay the mortgage. What tax implications are there for taking money out of a 401K or an IRA to invest in the bond market? We think that this might be the best way to go for us, but we have to look at the cost involved. Can you offer any information regarding this dilemma?
J.R., Arizona

Mr. Klotz responds: If you are not referring to your mandatory distribution, there can be penalties as well as tax consequences for withdrawing funds from a qualified plan. Typically, funds can be withdrawn from an IRA at the age of 59 1/2 with no penalty and mandatory distributions must be taken starting at age 70 1/2.

Because there are many different scenarios that might apply, we suggest you contact us or your tax advisor to discuss your specific situation.
4/15/05

Mismanagement when bonds are called?

As a trustee of a non-profit organization and without financial background, I am frequently confused at the discussions about the $30 million portfolio. Are there any rules that would point to carelessness? Twenty years ago, I was told that if bonds are called on a regular basis, it indicates a lack of attention because we should be selling them before they are called. What should I look for to determine if our broker's buy/sell recommendations are maximizing his commissions? If, for instance, we are investing $150,000, would it be better to buy one bond or three $50,000 bonds? I understand diversity is an issue, but are commissions and fees based on the total dollar amount or the number of bonds purchased?
P.H., Ohio

Mr. Klotz responds: Having bonds called does not reflect a poorly managed portfolio. Since most calls are announced 30 days prior to taking place, the bonds could not be sold at a high enough price to allow replacement of the income lost on the bonds about to be called.

Issues that are advance refunded (refinanced) to the call date are a different story. There is usually ample time to find an adequate replacement for these bonds since most pre-refundings are announced years before the actual call date.

Typically, when a bond is pre-refunded, its maturity is shortened to the call date and the quality is enhanced because the bond to be called is escrowed in Treasury bonds. This causes a rise in the bond's value and a reduction of its yield, making an exchange for higher yield much more feasible. In most cases, this will also result in capturing a profit on the sale. We recommend replacing bonds in these instances because it allows the investor to execute a buy and sell under the same market conditions, rather than being subject to unknown future market conditions at the time the actual call occurs.

Although it is difficult to give hard and fast rules for appropriate block sizes, $150,000 in one bond is not considered a large purchase in a $30 million bond portfolio.

Yes, brokers compensation is typically determined by the size of the transaction. The number of bonds purchased usually equates to the total dollar amount.

4/15/05

Converting AMT bonds

Over the years, I've used the usual formulas of taking my federal tax bracket and the smaller correction for the state tax bracket in calculating the effective yield of a taxable interest investment and comparing the result with a non-taxable yield. In the past couple of years I've been subject to the Alternative Minimum Tax (AMT) and it appears that the effective interest earnings on bonds subject to AMT becomes significantly lower. Should these bonds be sold and replaced with non-AMTs or does the cost of selling and buying replacement non-AMT bonds result in a "wash"? This probably needs to consider the maturity of the AMT's but I would appreciate your thoughts.
E.S., New Jersey

Mr. Klotz responds: Since the lowest AMT rate is 26%, it is absolutely prohibitive for an AMT taxpayer to own municipal bonds that are subject to AMT.

$100,000 in AMT bonds paying 5% or $5,000.00 annually would net $3,700 per year after paying the AMT.

Converting AMT bonds to non-AMT securities would cost an investor between 25-40 basis points (your 5% yield might be reduced to 4.6% or 4.75%). This is a far less onerous price to pay.
4/11/05

Premium bonds

I will retire in about five years and would like to have some income and also be able to keep the feds from taking so much. What do you think? My wife and I have a joint annual income of about $115,000, which puts us in the 25% federal tax bracket. We paid about $2,500 last year in federal taxes. I would like to buy muni bonds, about $75,000 worth, with a maturity date of about 10 years. I don't mind paying premium prices based upon your explanations in other responses I read. However, will premium prices paid exceed the money we will make from interest earned over a 10-year period of time? Are munis suitable for us? I saw under one of your links - "insure bonds" - there was a column representing coupon, yield to maturity and, finally, worst yield. What is the difference between coupon and yield to maturity?
S.W.

Mr. Klotz responds: The coupon rate is the fixed rate of return paid annually on the face value of the bond. This figure never varies regardless of the bond's price. Price changes are reflected in the yield. When prices rise, yields drop.

When the yield is lower than the coupon rate, the bond trades at a premium price. If the yield is higher than the coupon rate, the bond trades at a discount.

The worst case yield reflects the lowest possible return that the bond investment can produce. This is usually the yield to call on premium bonds.

When buying premium bonds, every dollar invested (including premium dollars) is working at a rate at least equal to the worst case yield. Therefore, income earned will always exceed the premium paid.

For more on premium bonds, you may wish to read a past article on "Finding Value in this Market."
4/8/05

Laddering if interest rates jump?

Regarding your articles about problems with laddering: have you considered that if interest rate jumps to 10%, your original investment of $500,000 will decline? The principle investment value will be much less than $535,000.
W.L., Maryland

Mr. Klotz responds: For "buy and hold" investors, market value is irrelevant. It is the additional interest received that distinguishes the long-term approach from laddering and produces more reinvestable income.

Over the life of long-term bonds they are sometimes worth more than their original cost and sometimes less. In either case the higher cash flow keeps coming. If long- term rates jumped to 10%, the additional income generated by the long-term portfolio would allow for reinvestment at these higher rates.

The laddered portfolio, while sacrificing 25% to 40% of income on a current basis, still only has bonds maturing every two years. When a short-term bond matures, the laddering strategy calls for buying a 10-year bond, which again will probably produce only 50% to 60% of the long rate.

Remember, any period of time that the U.S. economy experienced 10% rates was subsequently followed by a recession, which brought much lower interest rates.
4/8/05

Barbell?

I have recently refinanced property I own that had $975,000 in equity. Now, after the refinance, I have about $480,000 left in equity and I will receive about $400,000 in cash. I'm 35 and already have $150,000 in the stock market (half of that is in my retirement accounts). My federal, state and local tax rate equals about 40%. I am not really interested in buying a place to live at this time. I am very interested in buying into the bond market, with two goals in mind: decreased tax liability and increased cash flow. I'm new to your site, so am only beginning to find out that you are the first source of information of the many I've consulted cautioning against a laddered municipal bond portfolio. But I wonder, what your thoughts are on a barbell portfolio? Or do you think it's best simply to go for the highest yields within my comfort zone?
N.D., New York

Mr. Klotz responds: We agree with your last thought. Determine the amount of funds that you can comfortably earmark for long-term investment and buy the highest yields available, commensurate with satisfactory credit quality.

The barbell approach sacrifices so much income that regardless of the direction of interest rates, you will be hard pressed to equal the return on long-term bonds even if rates do move higher.

The theory behind the barbell approach is to maintain some "dry powder" if interest rates rise and then commit these funds to long-term bonds. In our experience, picking this entry point is extremely tricky. Haven't all the experts been predicting higher rates for the last four years?
4/5/05

On "ETMs and You"

Excellent article. It's disappointing that even The Wall Street Journal gets it half right, although they are consistent. My experiences with your organization have been excellent and I appreciate the expertise.
M.P., Florida
3/30/05

*****

Agree
B.T., Michigan
3/29/05

On "Muni Bond Holdings Hit Record"

Too bad for them as rates have been steadily rising!
J., New York

Mr. Klotz responds: Long-term investors buy bonds for income. Long-term interest rates are lower today than when the Fed started raising rates in June 2004.
3/29/05

Flat tax?

I think tax-exempt bonds are great but what do you think will happen to bonds when Congress passes a flat tax?
D., California

Mr. Klotz responds: We think any change in the current tax code would be designed to have very little impact on the municipal bond market.

Although we don't envision the enactment of a pure "flat tax," the tax-reform committee may recommend some version of a "consumption" tax. Most of the consumption tax proposals that are being discussed still project higher tax rates for wealthier taxpayers, who would still invest in munis for higher after-tax yields.

There are other reasons that suggest the effects on the municipal bond market would be minimal, including:

* Yields on long-term AAA tax-free bonds are pretty much the same today as the yields on long-term Treasury bonds. This means they are already inexpensively priced compared to taxable securities.

* The municipal bond market was created to allow states, municipalities and political subdivisions to borrow at reasonable rates for construction of "public purpose" projects (sewers, schools, etc). Since the public cannot afford to compete in the private sector capital markets, some mechanism would be required to accommodate borrowing for public projects.

Powerful private interests, the budget deficit and the Alternative Minimum Tax problem make us less than optimistic that any tax reform package will be enacted over the near term.
3/28/05

Muni bond investing at 70

Your Web site is full of excellent and useful information on investing in municipal bonds. However, I am 70 and retired (my wife is 68) and we need to produce about $35,000 per year in after-tax income from a muni-bond portfolio for the next five years and then have it adjusted to cover cost-of-living increases as they occur. I would hope to live to 90, or about 20 years from now, which would be my investment horizon. In my case, the use of 30-year bonds would not be feasible, (in 30 years I would be 100). Therefore, what is your strategy/opinion on investing in intermediate-term munis (20- year bonds) in our particular case?
R.S., Florida

Mr. Klotz responds: Your goal should not necessarily be to outlive your investments. The goal should be to create as much income as possible in your lifetime, since bonds are treated the same as cash in your estate. Over the years we have also found that individuals are not always accurate when pinpointing their own "maturity date."

We cannot answer your questions regarding your income needs without knowing the amount of funds available for investment.
3/28/05

Virginia resident, California bond funds

I recently inherited some shares of two tax-free California bond funds. I am a Virginia resident but have a small amount of California income from a rental property there and therefore do file a non-resident California state return along with my Virginia return. Are these type of funds generally tax-free to in-state residents only? Is there a reason for a Virginia resident to hold California bonds? My inclination is to liquidate them, though I'd be interested in your thoughts.
S.B., Virginia

Mr. Klotz responds:Your inclination is correct. Your California bond funds are subject to Virginia State tax.
3/28/05

New bond issues

I am unable to determine how I can purchase municipal bonds during the "initial offering period" when the purchase fees are paid to the initial seller. It appears that the brokers are now buying up the bonds for their own accounts and then selling them back to their clients at an additional fee. I consider this double dipping and taking unfair advantage of their clients! How do I prevent this? What system and procedure is necessary?
F.P., Arizona

Mr. Klotz responds: Your broker should be willing to take your order for a new bond issue if his firm is involved in the underwriting syndicate. If your order is submitted during the "order period" and the bonds are available, you will receive your bonds at the original terms. If it is a "hot issue" and the order period is "oversubscribed," larger orders will take precedence and your order may not be filled.
3/28/05

GM

Can you give me your opinion on GM? Based on the legacy of the pensions and medical cost they have, their poor lineup of cars, loss of market share and high gas prices, I see no way they can avoid Chapter 11 if they want to level the playing field and be able to compete with Toyota and the likes.
J.P., Florida

Jay Abrams, Chief Municipal Credit Analyst, FMSbonds, Inc., responds: Clearly, as you mention, General Motors is facing onerous internal burdens related to employee retirement and health costs while also being challenged by an unfavorable market reception for its cars. The important question to ask is whether GM can weather the storm. We believe it will.

GM's recent abrupt announcement that it was revising its earnings estimates downward surprised Wall Street and brought negative reactions from all three rating agencies. The company's new estimates foresee a first quarter loss and reduced earnings for the year to the $1 to $2 per share range.

We see no cause for panic. The automobile industry is cyclical by nature and its major players have gone through this before. Chrysler, the smallest of the "Big Three," offers the best turnaround example.

GM's challenges are great, but so is its opportunity. The company, and its GMAC subsidiary, are sitting on approximately $50 billion in cash, it is still forecasting a positive bottom line, and despite market share erosion, remains North America's largest automaker. Certainly, if GM were to do nothing, the slide would continue. But, that is not likely to be the case. We believe both GM and the United Auto Workers recognize that health care and pension costs must be brought under control if GM is to remain competitive in its markets. We also believe that GM will undertake a reorientation of its brands and models to better suit changing consumer tastes.

This all takes time. In fact, things may get worse before they get better. But, GM has weathered two world wars, the Great Depression, oil shortages and countless economic downturns. At this point, we see no reason to believe GM won't turn the ship around. GM has the resources and, we believe, the support of labor to reform itself and remain a major automobile producer, although likely on a smaller scale.

For GM bondholders, we believe the company's problems will have few repercussions on its debt. GMAC bondholders, in particular, are secured by automobile loans made in the past to purchasers of GM's cars. People making car payments don't stop because the company's earnings forecast has changed. Second, GM has numerous assets it could monetize if it needed to raise cash. And cash will be plentiful in the foreseeable future. Third, should a rating downgrade occur, it by no means portends a bankruptcy. Many of America's largest companies (such as Georgia-Pacific) are rated in the "BB" range, are profitable, and continue to make timely debt service payments.

In summary, we acknowledge the problems GM faces, but we also recognize the resources GM has at its disposal to become a smaller, more nimble competitor in the world's automobile markets.

3/28/05

Where are we?

Your Web site is excellent, concise, thorough and complete. One piece of information I was not able to find was the physical location of FMSbonds. Where are your headquarters located and where do you have branch offices? Do you have any offices in New Mexico? I am kept well informed of new bond offerings by Edie Nasello, for which I am most grateful.
A.C., New Mexico

Mr. Klotz responds:We serve muni bond investors from across the country from our offices in Boca Raton, Florida, where our Internet division is located, and North Miami Beach, Florida. This, and other biographical information, can be found on the About Us page of our Web site. Thank you for the kind words regarding Edie. We are also pleased with the way she represents our firm.
3/23/05

Learning more

I'd like to get smarter about muni bonds. I want to learn more about bond ratings and bonds that aren't rated (NRs). I'd like to know how to tell if the bond has been making payments and learn any important news such as credit upgrades or downgrades for the writers. Also, there are different bond types: Health Care Facility Revenue Bonds, Airport Revenue Bonds, Industrial Development Revenue Bonds, etc. What are the default risks or down sides to these different classes of bonds? How do I find out when their bond ratings were last reviewed? I'd bet that there is some honey to be found in bonds that aren't rated, bonds whose ratings have not been reviewed in some time, bonds with higher coupons, trade below par and may be callable. I would suspect these would be available in odd lots.
C.S., Florida

Jay Abrams, Chief Municipal Credit Analyst, FMSbonds, Inc., responds: As far as learning more about the tax-exempt bond market, bond types and ratings, we can recommend two books that are highly regarded: The Bond Market Association, The Fundamentals of Municipal Bonds, (Wiley, 2001), Fifth ed., ISBN: 0471393657. Robert Zipf, How Municipal Bonds Work, (New York Institute of Finance), ISBN 0131226568.

For detailed information on bond ratings, including their methodology, you might try the Web sites of the three major rating agencies: Moody's Investors Service: www.Moodys.com, Standard and Poor's: www.standardandpoors.com and
Fitch: www.fitchratings.com

While all three are designed to serve market professionals (with fees to match), they do provide limited free access. They will provide the criteria used by each agency to rate various bonds, rating trends, access to actual ratings and rating reports and other articles of interest. Further details may require a paid subscription.

Non Rated (NR) bonds will not be accessible from the rating services. You would
need the help of a broker to determine relative values for this class of bonds.
3/11/05

Bonds for California residents

I am 55, looking to retire and need to produce about $350,000 per year after-tax income from a muni-bond portfolio for the next 10 years, and then have it adjusted to cover cost-of-living increases as they occur. I would expect to live to 85 years, or about 30 years from now, which would be the investment horizon. I am a California resident and thus prefer a CA muni portfolio so that it is double tax-free here. How do YTMs (yield to maturities) on 20- to 30-year munis compare using out-of-state issues vs. CA issues, assuming comparable risk parameters? Is there a better annual cash-flow return from a national muni-portfolio if one were to relocate to a state like Florida? I have read your strategies page and have learned that committing to the highest yield instead of laddering (which is what most financial advisers suggest!), is the better strategy. Therefore, what is the best strategy to achieve this investment scale and how much time will it take to assemble such a portfolio?
S., California

Mr. Klotz responds: You will find since the California State tax on out of state bonds can be as high as 9.3% of income, California issues or bonds of U.S. territories are your only reasonable choices. Out of state purchases will become even more prohibitive if any new tax law eliminates the deduction of state tax from your federal taxes.

There is no question that the cash flow would be greater for a Florida resident since there is no state income tax in Florida.

Naturally, the ability to produce $350,000 of annual income would depend on the amount invested and the prevailing rates at that time; $7 million invested at an average rate of 5% would yield $350,000 in annual income. An average rate of 4.5% would require approximately $7.75 million to produce the desired income.
3/8/05

Buying out-of-state bonds

My home state is CT. My advisers often tell me that a purchase of out-of-state bonds will be better than acquiring more CT bonds. When I ask why, I can never get an answer that completely satisfies me. They mention diversification, ratings and AMT but does it always come down to personal judgment? Is there a more technical answer? Also, I am considering buying Nuveen MuniPreferred (CT or not?) for some short-term funds. Do you have any comment on that?
J.W., Connecticut

Mr. Klotz responds:We must confess that we also can't understand why your advisors would recommend out-of-state municipal bond purchases to a Connecticut resident. The state has enough issuers to provide ample diversification and enough insured bonds to provide more than adequate security without shrinking your yield by paying state taxes on your tax-free income. We think that the Nuveen Preferred funds make sense as a "parking place" for funds awaiting investment. Nuveen offers a Connecticut version of this fund. Please be aware that these funds differ from traditional money market funds and can only be liquidated on specific dates.
3/8/05

Bond miscellanea

How can you find out when dividends are paid on muni bonds? Do they have an ex-dividend date like stocks? How is interest paid to (say new buyer)? Is interest prorated between old holder and new holder? Seems like you should know these things when buying tax-exempt bonds.
K.B. Alaska

Mr. Klotz responds: The vast majority of municipal bonds pay interest semi-annually.

You are correct. If a bond is bought or sold in between payment dates, the accrued interest is prorated to reflect the number of days since the last interest payment.

Interest on tax-free bonds is computed on a 30-day per month/360-day per year basis. There is no ex-dividend date.
3/7/05

When do you load the boat?

Your website is full of excellent and useful information on investing in municipal bonds. I know your feelings on buying good quality bonds when the money is available for investment. In your tenured opinion, doesn't it seem that rates just do not seem all that exciting at the moment? And I realize that you probably are constantly buying, but is there a rate at which you really step up and load the boat? Again, you guys do great work, and when you said that rates might peak out after the first rate increase, you could not have been more correct. I know that you do not time the market, but you were correct.
A.C., New Jersey
2/9/05

Mr. Klotz responds: Thank you for the kind words. As you know, we also say that trying to forecast the future direction of interest rates is a treacherous and unrewarding pursuit. Although we always carry a large inventory of tax-free bonds, there are times when we think the muni market is particularly attractive. Most important to us is the relationship between tax-free and taxable yields. Even though tax-free rates may appear low, AAA munis yield as much or more than comparable Treasury bonds. There is also a decided yield advantage when compared to high-grade corporate bonds.

Yield curve

We all know about the yield curve, which shows that the mid range is the best place to buy bonds. That is 10 to 14 years out. In the current interest rate climate, why lock yourself in for 30 years? I ladder my portfolio by buying 10- to 12-year bonds, preferably Baa. I have been doing this successfully for 35 years.
A.F.
2/9/05

Mr. Klotz responds: We agree that in today's market, there is value to be found in the intermediate range of the yield curve because the curve has flattened since last summer. As you know, this has not always been the case.

We are sure that your strategy has served you w