Muni Bonds Pay A 7.12% Equivalent Yield? Yes!

I just had a buddy buy into a Municipal Bond that is yielding an incredible amount so I thought I would write a post about it. Sorry the post is so long, but I'm excited. First of all:

What is a Municipal Bond or Muni Bond?: From Investopedia: A debt security issued by a state, municipality, or county, in order to finance its capital expenditures. Municipal bonds are exempt from federal taxes and from most state and local taxes, especially if you live in the state the bond is issued.

The key part of this definition is "exempt from federal taxes and from most state and local taxes"; Yes!

So what did my buddy buy into? Through his broker, he bought a single $10,000 bond issued by a local school district here in Southern California. The bond was issued by the district about 7 years ago, so he actually paid $10,800 for it. Okay, this will need further explanation.

When a bond is issued, it has a face value; in this case $10,000. It also has a fixed interest rate; in this case 5.5%. So in this case, a fixed annual payment of $550 paid in two payments of $275. It also has a fixed term; in this case it is 30 years unless it is redeemed by the issuing agency. My buddy's bond has 23 years remaining.

However, bond values (i.e. the $10,000) will rise and fall based on interest rates. But at the end of 30 years, the bond will return $10,000 to the investor (provided the entity is still in business).

So what happens to the extra $800 my buddy paid? Remember, he paid $10,800. The $800 is called a premium. After the end of the 30 years it just goes away. So when he figures out how much this bond paid him in interest, he has to deduct this $800 from his earnings. And I will show that calculation by deducting that $800 equally over the remaining 23 years (called amortizing).

Next question: I can lose money on this right? Correct, you can lose money. This is why they have bond ratings. The bond my friend bought is rated AAA which is the highest rating a bond can have. So what can go wrong? Suppose the school district in question loses some funding from the state or county, their bond rating my fall and if it falls too far, the bond price could fall a lot. Remember though, if the entity stays viable for 23 more years, you will always get your $10,000 back. If they don't make it, you lose. In general though, these things tend to be pretty safe. But do some homework!

Next question: Do I have to wait 30 years to redeem this? Nope. You can sell the bond at anytime. However, you will be subject to whatever the price is that day(i.e. the $10,800 price my buddy paid). So after any amount of time, you can sell it for the going price; could be $11,200, could be $10,500, could be $9,800, could be anything. If you wait the term of the bond (23 remaining years) you get $10,000.

Okay, now the fun part. How the heck is this thing yielding 7.12%? Bear with me here as we walk through it. Suppose you have an ING Direct savings account that pays 4.4% interest. Lets use the same amount of $10,800. If you put that money in ING, you would earn $475 per year. Now if you put that $10,800 in the muni bond (it pays 5.5% interest) you would earn $550 per year. However, we have to amortize that extra $800 over the remaining 23 years because we don't get that $800 back($800 divided by 23 equals about $35). So you would actually earn $515 ($550 - $35). Now, divide the $515 you earned by the $10,800 you invested. Answer 4.7%. WTF!!!!! I thought this thing yielded 7.12%.

Because there is more! Oh boy! If you invested in ING, you are paying taxes on the $475 you earned in interest. So now take that $475 and deduct your federal and state taxes. I'll use a rate of 25% for federal and 9% for California (stupid CA taxes). So we take our $475 we earned and subtract $162 ($475 times 34% (25% + 9%)). So now we have earned $313 after tax. $313 divided by our investment of $10,800 = 2.9%. Damn. That pretty much sucks. Remember above, our muni bond is yielding us 4.7% and there are no taxes on the earnings. So how much of a rate do I have to get in ING Direct to come up to 4.7% after I pay taxes?

More calculations. Fun. Basically you would have to earn 7.12% in ING to make the same earnings after taxes as the muni bond. Remember, this assumes a 25% federal tax rate and a 9% state tax rate. To figure out using your own tax rate, just take the 4.7% and divide it by 1 minus your rates. So I took 4.7% divided by 0.66 (1- .25 - .09).

So now what. I'm looking into this more. The account minimum is $10,000 (the face price of the bond), but I'm still exploring this further. There are other issues such as account fees and such, so I'm going to do some more homework.

Leave a comment if you are interested in some followup on this topic and I will post more when I get the info.