A Connecticut client wants information on tax free bonds. She’s heard that tax free bonds can save her money and wants to invest $5,000 each month. As an advisor, you understand the importance of buying bonds at the best price. Interest rates are at historic low levels at year-end 2010. Your client may not understand that municipal bonds don’t work the same way as savings bonds or T-bills. At $5,000 per month, your client plans to invest $60,000 each year in tax free bonds. Is the client best served by purchasing individual bond issues, a unit trust or a municipal bond fund? Help to educate your client.Difficulty: AverageTime Required: 1 hour
- Discuss how municipal bonds compare and contrast to a U.S. Savings bond instrument. Original discount municipal bonds, or those issued at lower interest rates than the current market, may trade a levels below 100 percent or par. Municipal bonds are generally issued at par value, and mature at par value. Zero coupon municipals — those that pay no current interest and accrue interest until payment at maturity date — also offer an original discount structure.
- Compare after tax returns in the client’s portfolio. She earns 0.74 percent on Series I savings bonds due in April 2011. In the current climate, that’s an attractive short-term rate. The client understands that buying longer-term maturities will help her achieve more income, but she doesn’t want to extend maturities more than 10 years. For example, 2-year maturities average about 0.74 percent, according to Bloomberg.com. On an after tax-adjusted yield basis, that’s more than 1 percent return for two years. At 10 years, municipal bonds average a yield just under 3.5 percent. The after-tax yield is under 5 percent.
- Contrast Treasury bond rates in the same maturity level. The U.S. Treasury bond market yields about 2.625 percent at year-end 2010. According to the Internal Revenue Service Publication 17 (2010), Treasury bond interest is subject to federal taxes and free from state and local taxes. She will save money on Connecticut taxes: Connecticut taxes the first $20,000 of income at 3 percent for the first $20,000 and 5 percent for a single filer’s additional income. The municipal bond’s after tax return contrasts favorably with T-bond after tax returns.
- Explain the historical safety of municipal bonds. If your client wants an high quality municipal bond, explain the investment grade rating system and a href=”http://financialservices.about.com/od/GlossaryFA/Nationally-Recognized-Statistical-Rating-Agencies.htm”> Nationally Recognized Statistical Organizations (NRSOs). Standard & Poor’s, Moody’s, Fitch’s and others analyze and rate municipal bonds for credit quality. Most state General Obligation bonds (GOs) are considered of investment quality, A-rated or better.
- Ask your client about preferences in purchasing municipal bonds. Open-ended Connecticut tax free bond funds buy municipal bonds according to the fund prospectus. Mutual funds must charge to manage and administer client funds, so expense ratios of about 1 percent apply. Because funds purchase many municipal bond issues, the risk of owning a diversified bond fund may be less. The client may elect to receive a monthly check with the bond fund.
- Instruct your client about the differences between individual bonds and financial products, such as bond funds and unit trusts. Individual bonds pay coupon interest twice per year. Purchase of less than $25,000 or $100,000 of bonds may be considered an odd lot. That means the bonds may cost more, and the yield may be lower. Provide your client with the preliminary prospectus of any new issue municipal bonds that meet her needs. Discuss any upcoming municipal bonds by introducing your client to the Municipal Calendar.
- Talk about municipal bond unit trusts with your client. Unit trusts differ from open-ended bond funds. The unit trust portfolio managers purchase a diversified portfolio of municipal bonds according to the prospectus. Unless credit rating or other concerns prompt the managers to sell individual bonds, passive portfolio management of the fund applies. The unit trust structure provides a monthly check and ready liquidity of the units.