Our final Puerto Rico discussion is later this week and focuses on their Public Debt/Municipal Bond situation. As a primer, we wanted to dig a little deeper into our good friend the Muni Bond.
What is a bond?
A bond is generally a debt instrument issued for an amount of money with a promise to return the amount in the future for a stated interest rate. As an example an issuer may sell his instrument for 15 years and pay an annual rate of 6% with the promise to give back the principal at the end of the term.
What is a Muni Bond?
A Muni or Municipal Bond is a special bond (debt instrument) that is issued by a public agency (think city, public stadium, transportation road, water utility, just to name a few) and in most cases pays income tax-free to investors.
Tax Free Income, but with a Catch
As mentioned above, the income from Muni’s are generally tax-free, however there is a catch. The income from a Muni is generally lower than that from a non-muni similar bond. Without getting into the weeds, if a 5 year regular bond yields/pays 5%, a similar muni bond might only yield 3%, but the investor need not pay taxes on the muni bond income/interest received. Each investor’s tax rate determines the best bond for their situation.
Bonds Can be Complicated
Unlike stocks/equities, bonds can be complicated. Generally, the stock of company ABC has only one class. The city of ABC may have dozens of different bonds with more or less covenants (restrictions, bylaws, and safety features.)
While investors can easily purchase one share of stock, muni bonds are best traded in $100k lots, also known as “Round Lots.” Trading smaller lots/amounts of bonds may lead to less efficient executions. An investor can also purchase muni’s via ETF’s or mutual funds as well, especially helpful for smaller dollar purchases.
Our favorite Muni bond is call a GO, or General Obligation bond. This means the bond is not focused on one single project or revenue source. Generally speaking for a GO to default the entire agency must default, which usually does not happen as a surprise. Detroit was on notice for years, as is Puerto Rico today.
While not exhaustive, this Muni Primer should have us all ready for our final Puerto Rico post later this week.
Have a Great Monday!
John A. Kvale CFA, CFPhttp://www.jkfinancialinc.com http://www.street-cents.com 8222 Douglas Ave # 590 Dallas, TX 75225