Financial Problem Solved! "This bond looks good, but. . . "

July 25, 2003

Munis can be risky when the economy's rocky.

 

FINANCIAL PROBLEM SOLVED!

"This bond looks good, but . . ."

Problem

My city is issuing municipal bonds to build a new stadium, and I may invest $30,000. I'm in a high tax bracket, and I'd like to support my city and the local sports franchise. But I've heard that munis can be risky when the economy's rocky. Should I buy?

Solution

To decide, you'll have to weigh the pros and cons. One possible downside is that the "bond bubble" may soon pop. In recent years, bonds have benefited as interest rates have declined. But now rates are more likely to rise, causing outstanding bonds to drop in price.

On the plus side, municipal bond coupon payments are free of federal taxes. And since you're considering bonds from your own city, they'd also escape state and local taxes. If you're in the 35 percent marginal tax bracket and your state tax is about 6 percent, you'd need to get a return of 4.93 percent from a taxable investment to equal a municipal bond's 3 percent after-tax return. You can calculate a municipal bond's pre-tax equivalent at www.investinginbonds.com.

Also consider the bond's safety. There are two types of municipal bonds: revenue and government obligation. Revenue bonds pay interest and principal from revenues brought in by the project they fund. If revenues aren't high enough, the issuer will default and payments to bondholders will be deferred. With general obligation bonds, payments are virtually guaranteed, because if the township needs cash to pay bondholders, it's obligated to tax residents to raise the money.

The bonds you're considering will probably be the revenue type, which are much riskier than general obligation bonds. If you're a cautious investor, you'd be better off with government obligation bonds.

Assuming you're still interested in the stadium bonds, request an annual report and as much information as possible on the company running the project. Find out whether its prior projects have been profitable. Here are some other questions you should ask when evaluating any municipal bond:

What kind of rating does the bond have? I recommend investing only in high-quality munis—those rated AA or AAA by Standard & Poor's, or equivalent ratings from other firms. In this economy, you've got to be very careful about financial strength. If business is difficult over the coming years, municipal bonds may default more frequently than in the past. And any bond's rating could deteriorate over time, so it's best to start high.

Is the bond issue insured? Insured bonds are safer than uninsured ones, because the insurer guarantees to pay the interest and principal in case of default. Only creditworthy bond issuers can get insurance.

What coupon rate is the city offering? Look for bonds paying at least 5 percent, to build in a little protection in case interest rates rise. Selling the bonds before they reach maturity will prove difficult if investors can get better rates elsewhere. And if your money's tied up in them, you'll miss out on the opportunity to earn better returns.

How long is the term? The longer it is and the lower the coupon payments, the more sensitive the bonds will be to interest-rate changes. I'd suggest staying with maturities of under 12 years.

A final caution: Certain bonds used for construction of sports facilities (so-called "private purpose bonds") may subject you to the Alternative Minimum Tax. So before buying these bonds, check with your CPA to see if that's the case.

This issue's problem solver is Bill Matthews, CFP (bill@mattfin.com), a financial adviser with Matthews Financial Services, Dallas, TX. Financial Problem Solved! is edited by Senior Editor Leslie Kane.

 

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Leslie Kane. Financial Problem Solved! "This bond looks good, but. . . ". Medical Economics Jul. 25, 2003;80:57.