Safety of Municipal Bonds NEW ARTICLE
Are Municipal Bonds For You?
Nine Steps to Raising Money-Smart Children
TIPs vs. I Bonds
How is I Bonds interest determined?
Savers Lack of Attention Incredibly Costly
Did You Know?
- Some of your savings bonds may not be currently paying you any interest at all.
- Strategically redeeming certain savings bonds over time may save you thousands of dollars in interest and/or potential taxes.
- It is easy to find out exactly what your specific savings bonds are paying and for how long.
U.S. Savings Bonds
If you own U.S. savings bonds, an appropriate exit strategy could literally save you thousands of dollars. For example, investors may be able to avoid being bumped into a higher tax bracket by simply spreading out their bond redemption over numerous years. Selecting the least beneficial savings bonds to redeem first, and holding certain others somewhat longer, is also a smart strategy. EE bonds purchased from June 1994 to April 1995 have a special catch up feature that boosts the rate of return to an annualized rate of 16% during one six month period in the fifth year of ownership. Savings bonds purchased after May 1997, on the other hand, impose a three month interest penalty for selling in less than five years. The EE savings bonds issued from May 1995 to April 1997 are pegged to market rates every six months, and thus, have consistently been the lowest yielding among the group over the past several years. Cashing in Bonds at the wrong time cost savers an estimated $100 million a year in lost interest. In addition, there are nearly $6 billion of savings bonds still out there that have ceased paying interest altogether.
Investors can write to the Bureau of Public Debt, P. O. Box 1328, Parkersburg, WV 26106 or better yet, visit their web site at http://www.publicdebt.treas.gov/sav/sav.htm (Press back button to return to soundinvesting.org). From that site you can download the savings bond wizard. Then all you have to do is type in the serial number and date of issue of your savings bonds and the program gives back the current value, the interest earned, the date of the next interest accrual, the yield to date and when the bond will stop paying interest. The web site will also tell you what rates (typically 4-6%) any savings bond currently pays as well as how long they will stay in effect. This is essential information in determining if your savings bonds are worth holding.
Currently, inflation adjusted savings bonds may offer the best potential. Treasury Series I Bonds offer a fixed yield adjusted annually for inflation. It should also be noted that there are specific tax advantages with U.S. savings bonds. They are exempt from state and local taxes and federal tax liability in deferred until redeemed. If proceeds are used for higher education purposes federal taxes may be avoided altogether - one should consult with a tax advisor for specifics to your situation.
The following is a list of of U.S. Savings bonds with 0% interest.
- Series E bonds issued in June 1959 and earlier.
- Series E bonds issued from December 1965 to June 1969.
- Series H bonds issued from 1952 to June 1969.
- Savings Notes/ Freedom Shares issued from May 1967 to June 1969. These bonds, issued during the Vietnam War period, bear the words "Freedom Share" and do not have a letter "E" after the serial number. The last Freedom Shares will stop earning interest in October of 2000.
- All series A, B, C, D, F, G, J and K bonds.
Series E Savings Bonds revised their rules in 1965 and this has left many older bonds earning no interest. Under the revision, Series E Bonds issued through November, 1965 earn interest for 40 years. The bonds issued in December, 1965 and later earn interest for 30 years. Latest data suggests that there is more than $6.5 billion in savings bonds that have not been cashed in and that are not paying interest. Many banks no longer bother to train their employees in savings bond management. In addition, the U.S. Government despite occasionally switching rules, doesn't bother to send statements outlining your holdings. Therefore, you must educate yourself to make sure you get the most out of your savings bonds.
If you're not sure of the status of a bond, look at the issue date on the upper right hand corner. Any bonds issued from 1941 through October 1959 have stopped paying interest, as have bonds issued from December 1965 through October 1969. Interest rates depend on which bonds you bought, newly purchased EE bonds earn a market-based rate equal to 90% of the average of Treasury issues with five years left to maturity. The rate, 4.31% as of October 1999, is reset every six months. Inflation protected Series I Bonds, which we suggested and detailed above, now pays 5.05%. One final suggestion when cashing in savings bonds, calculate your total proceeds beforehand, just just to make sure your redemption check from the bank is full and accurate.
According to the latest Federal Reserve data, American Savers hold $1 trillion in low yielding savings accounts that average 2.1% interest. Much higher interest rates can be easily obtained from bank money market deposit accounts, certificates of deposits (CD?s) and money market mutual funds. Yet savers continue to leave $30 - $50 billion on the table each and every year by accepting of 2 - 3% and sometimes even less. In contrast, many CD?s of six months or one year, and money market funds are currently paying 6 ½ - 7% or even slightly higher. The impact of this difference over any significant length of time becomes truly amazing. At 2.1% the $1 trillion currently in such low paying savings would be worth $2.3 trillion by 2040. The same amount invested at 7.1% annually would yield $15.5 trillion - approximately seven times more return for each saver?s dollar.
Currently, approximately 7% of American households keep more than $25,000 in these low paying savings accounts and about 43% of them are 65 or older (the group that could most benefit from obtaining higher rates). Over 15 years, that $25,000 could yield $50 more a month even if were invested only at 6% compared to its current 2.1% average. So make sure all your savings are earning the appropriate safe returns - here is description of your various options?
Bank Money Market Deposit Accounts: These offer FDIC Insurance, total liquidity and as of December, 2000, average yield in the 6% range.
Certificates of Deposit: Many banks and savings and loans are currently offering around 7% for six or twelve months guaranteed accounts which are also insured.
Money Market Mutual Funds: These funds are not guaranteed by the FDIC but are privately backed by the mutual fund industry, while it is possible to lose money, not one has ever had the misfortune and it is unlikely if the fund is properly managed. These funds offer liquidity, check writing privileges and high interest that rises with the market.
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TIPs vs. I Bonds
The Treasury has 2 types of inflation adjusted securities offered to the public. Though both serve to address the impact of inflation on fixed income investments, the two have significantly different components and MUST NOT be confused. The products are TIPs (Treasury Inflation Protection Securities) and I Bonds (Inflation adjusted savings bonds). Generally, interest on such Treasury bonds are exempt from state and local income taxes, but bonds are subject to other state and local taxes as well as federal taxes.
What are TIPS?
TIPs are the Treasury's original Inflation Adjusted securities. These bonds are coupon issues designed to reflect the change in the rate of inflation (as measured by the CPI-U) to protect the holder from loss of purchasing power (due to inflation) during the life of the bond.
What are I BONDS?
I Bonds are the Treasury's inflation adjusted savings bond. These bonds are zero coupon discount bonds sold in the same manner as the traditional Series E & EE savings bonds. I Bonds are available via banks and directly from the Treasury. These bonds can earn interest for up to 30 years and interest earnings are payable upon redemption.
How do TIPs Work?
The Treasury auctions TIPs with a fixed coupon & maturity just like traditional Treasury issues. The investor receives semiannual interest payments on an inflation adjusted principal. TIPs like traditional treasuries are issued in minimum denominations of $1000 and can be liquidated at any time. The REAL yield (as some refer to it) of TIPs is the coupon rate PLUS the rate of inflation. This allows the holder to maintain purchasing power during periods of rising inflation.
Example: Client buys the 3 1/2% due 1/15/11 (current 10 Yr. TIP) and inflation runs during the 1st 6 months @ 3.0%. Client receives 1st coupon payment of $18.03 per bond (vs. $17.50 for the traditional treasury) as the principal base has accredited to a value of $1,030.
How do I BONDS Work?
I bonds are issued with a fixed maturity and yield (based on the purchase of a 30 year bond). The rate for I Bonds is set on May 1 & Nov. 1 of each year. That rate applies to all I Bonds offered during that 6 month period. I Bonds are sold in various denominations from $50 to $5000. Also, I Bonds redeemed within the first 5 years are subject to a 3 month earnings penalty.
What Happens To The Inflation-Adjusted Principal During the Term of the TIPs Bond?
The principal is adjusted daily by the CPI-U. During periods of inflation, the principal value will accrete positively and would be realized if sold prior to maturity. During deflationary periods, the principal value will decrease and MAY cause interest payments to be less than the stated coupon. However, bonds held to maturity will return a minimum of par (regardless of deflation) and would realize full inflation accretion.
What Happens To The Inflation-Adjusted Principal During the Term of the I Bond?
The current I Bonds will accrete at a rate of 3.00% (current I Bond yield through 10/31/01) above the rate of inflation. The treasury will re-set the yield every six months.
What Is The Tax Status of TIPs?
As with traditional Treasuries, income is exempt from state & local taxes. However, the inflation accrual of the principal is subject to OID and would be federally taxable in non-qualified accounts, even if bonds have yet to be sold
(sometimes referred to as phantom income).
What Is The Tax Status of I BONDS?
This is one of the major differences between I Bonds & TIPs. As with all savings bonds, tax liability is deferred until the bonds mature or are redeemed. Many investors mistakenly believe that TIPs also defer taxes. Clients MUST understand
the difference between the TIPs coupon notes & the I Bond savings bonds.
What TIPs Issues Are Currently Available?
The following issues are the 'current' outstanding TIPs:
3 3/8% 4/32 New 30 1/2 Yr. App. Yld. 3.40%*
3 1/2% 1/11 Current10 Yr. App.. Yld. 3.05%*
There are also off the run TIPs notes (maturing between 2002 & 2010) and an off the run bond maturing in 2028 and 2029.
When Is The Next TIPs Auction?
The Treasury has tentatively scheduled to auction 10 Yr. TIPs in January.
For more information regarding TIPs access the Treasury's Website at: http://www.ustreas.gov/.
For more information on I Bonds access the Treasury's Website at: http://www.ustreas.savingbonds.gov/
- A fixed rate that lasts for 30 years
- An inflation rate that changes every six months
I bond fixed rates are determined each May 1 and November 1. Each fixed rate applies to all I bonds issued in the six months following the rate determination. For example, a fixed rate determined on May 1, 1999 applies to all I bonds issued from May 1999 through October 1999.
DATE FIXED RATES* NOV 1, 2001 2.00% MAY 1, 2001 3.00% NOV 1, 2000 3.40% MAY 1, 2000 3.60% NOV 1, 1999 3.40% MAY 1, 1999 3.30% NOV 1, 1998 3.30% SEP 1, 1998 3.40% *annual rates compounded semiannually
The inflation rate is determined each May 1 and November 1. It is the percentage change in the Consumer Price Index for all Urban Consumers (CPI-U) over six months. Each inflation rate applies to all outstanding I bonds for six months.
NOV 1, 2001 1.19% MAY 1, 2001 1.44% NOV 1, 2000 1.52% MAY 1, 2000 1.91% NOV 1, 1999 1.76% MAY 1, 1999 0.86% NOV 1, 1998 0.86% SEP 1, 1998 0.62% *semiannual rates
COMPOSITE EARNINGS RATES
We combine fixed rates and inflation rates to determine composite earnings rates. An I bond's composite earnings rate changes every six months after its issue date. For example, the earnings rate for an I bond issued in March 1999 changes every March and September.
EARNINGS RATES THAT BONDS WILL BEGIN EARNING BETWEEN
NOV 2001 AND APR 2002
NOV 2001 - APR 2002 4.40% MAY 2001 - OCT 2001 5.42% NOV 2000 - APR 2001 5.82% MAY 2000 - OCT 2000 6.02% NOV 1999 - APR 2000 5.82% MAY 1999 - OCT 1999 5.72% NOV 1998 - APR 1999 5.72% SEP 1998 - OCT 1998 5.82% *annual rates compounded semiannually
HOW WE SET COMPOSITE RATES
Here's how we set the composite rate for I bonds issued Nov 2001 - Apr 2002:
Fixed rate = 2.00%
Inflation rate = 1.19%
Composite rate = [Fixed rate + 2 x Inflation rate + (Inflation rate X Fixed rate)] X 100
Composite rate = [0.0200 + 2 x 0.0119 + (0.0119 X 0.0200)] X 100
Composite rate = [0.0200 + 0.0238 + 0.000238] X 100
Composite rate = [0.044038] X 100
Composite rate = 0.0440 X 100
Composite rate = 4.40%
For more on I Bonds and if they are right for you click here.
Nine Steps to Raising Money-Smart Children
There are many things you can do and say to teach your children good money sense. Having once been a child yourself, you can always fall back on stories of how you used to earn, save, and spend money all those years ago. You can fill their heads with sermons on how important it is to be careful and wise with their money. However, the bottom line is that there's no better teacher than experience. The key to teaching your children one of the most important lessons of their lives is to have them learn by doing.
Following are a handful of ways you can encourage your children to save and manage money. In addition to the short-term benefit - namely, having children who realize that money doesn't grow on trees - you'll be instilling in them a healthy dose of financial responsibility that they can carry with them through adulthood.
Get children interested in money early
When your children are very young (perhaps at age three or four), show them how to tell different coins apart. Then give them a piggy bank they can use to store up their change. A piggy bank (or even a wallet or a purse) is a tangible place to keep their money safe. Using a clear bank is probably best, as this will allow your child to hear, feel, and see the money accumulating. This visual experience is the child's equivalent of an adult reading the daily mutual fund prices in the newspaper or examining a quarterly retirement plan statement.
Once the saving has begun, let children spend money on treats, buying things both when there are just a few coins in the bank and when it's completely filled. This way, they will come to realize that a little bit in the bank buys a small treat, but a full bank enables them to purchase something special. Then, once they're a little older, try playing games to help them understand the difference between "needs" and "wants." When riding past billboards or watching television, for example, ask them to identify whether each product advertised is a "need" or a "want." Tally their score, and when they've accumulated enough points by guessing 10 or more correct answers, treat them to a "want."
Make saving a habit
To get children off on the right foot, make a house rule of saving 10% or more of their income, whether the source of that income is earnings from a neighborhood lemonade stand, their weekly allowance, or a part-time job. If started early enough in the child's awareness of money, your plan shouldn't run into much resistance. However, if you don't set some sort of guidelines, chances are pretty slim that a child will take the initiative and save on his or her own.
For proof, all you have to do is think back to when you were a child. Can you honestly say you would have saved the money you received from a relative on your eighth birthday without a parental directive to do so? Chances are, you would have spent that money at the first candy shop you walked by. Like any positive behavior you try to instill in your child, saving money is a learned skill.
Open a savings account in a child's name
Like a piggy bank, a bank savings account can show kids how their money can accumulate. It can also introduce them to the concept of how money can make money on its own through compound interest. Start by giving your child a compound interest table (available for the asking at most banks) to let them anticipate how their money may grow.
Be sure to plan regular visits to the bank. Although these days many people find it easier to save via direct deposit, having your young child see you make regular, faithful trips to the bank can shape his or her own saving behavior. And, being able to participate in something a grownup does will make any youngster feel mature and responsible. In case you haven't noticed, children who accompany their parents to the bank invariably want to "fill out" their own deposit slips. Why not do it for real?
Encourage goal setting
Have your kids write down their "want" list, along with a deadline for obtaining the items on the list. For example, your child may want inline skates by the end of the summer, or a mountain bike by next year. Visualizing may give kids the added motivation they need to save.
You might also contribute a matching amount every time they reach a certain dollar amount in savings by themselves. Such a proposition sounds just as appealing to a child as it would to you if your boss told you the company would kick in a dollar for every dollar you saved over $10,000. Not only will such an arrangement make them work harder to reach their goals, it might also prevent them from thinking they'll be old and gray before they save enough for an item on that wish list. After all, a year is an eternity to a young child.
Give regular allowances
Allowances give kids experience with real-life money matters, letting them practice how to save regularly, plan their spending, and be self reliant. Of course, you should determine the amount of allowance you think fits their age and the scope of their responsibilities.
Some parents feel they don't have to pay allowances because they generously hand out money when their kids need it. But surveys have shown that kids who got money from their parents as needed saved less and were broke more often than children who earned allowances, even when the total amounts children in each group received were the same.
While you'll naturally decide for yourself when to start allowances and how much to offer your children, consider the following guidelines:
- Don't grant too much independence by telling them they can spend their allowances on whatever they wish. Make them save at least some of it, and then advise them to spend the rest wisely.
- Don't take away allowances as punishment. Allowances are an educational tool, not a disciplinary one.
- Carefully consider raise requests, and discuss with a child why he or she is making such a request. Spare yourself weekly petitions for raises by telling your children they can only ask for raises twice a year, and then stick to your rule.
- Don't reveal too much about your own finances when justifying reasons not to grant a raise in allowance. Simply explain that your own budget is limited, and that there is no extra money for a higher allowance.
- Don't be too generous. Too much money in a child's hands can breed careless spending habits.
Help plan a budget
Have your children write down what they'll buy during the week and how much each item costs. Then write down their weekly incomes. If they don't match up, they'll have to prioritize their "needs" and their "wants." To give younger children practice making tough decisions, allow them just one special treat - which they pick out themselves - at the grocery store. Having to face 10 or more aisles knowing they can choose something from only one helps children understand that spending means making choices. Just as you know fixing a leaky roof might mean postponing your Caribbean vacation, your children will realize that opting for an action figure during a store visit means they won't be able to enjoy a candy bar on the way home.
Encourage money-earning ventures
To help your children earn money beyond their weekly allowances, suggest to them that they find creative ways to make money. Encourage them to do special household chores, or to seek jobs in the neighborhood such as raking, mowing, pet sitting, or shoveling snow.
Many people in your neighborhood - particularly elderly residents - would love to have a "regular" person doing things for them they can no longer do. This is a perfect opportunity for your child to earn some money and to do something for someone in need. Even though by the teen years, many children begin earning money on their own by working part-time jobs, continue to encourage that entrepreneurial spirit. To supplement his or her income and help pay car insurance, for example, a teen might consider starting a car pool to and from school and charging passengers a nominal fee each week.
Show them the effects of inflation
To show your children how prices have risen over the years, take them to the library to look up ads - for movie tickets, bikes, sneakers - in the newspaper archives (try finding the year they were born). In addition to being a trip down "memory lane" for you, it can serve as both a financial awakening and a history lesson for your children.
Once armed with the knowledge that things will almost certainly rise in cost, your children can use their math skills to see how much items they're saving for will cost in the future. For example, a bike that costs $150 today might cost $180 in five years, with 4% inflation. If they're old enough, let them know there are ways to keep ahead of rising prices, such as investing in mutual funds, which have historically grown faster than inflation over time (although past performance is no guarantee of future results).
Of course, you should also tell them of the risks involved in investing. Let them know that the value of mutual funds fluctuates over time, and that they have just as good a chance of losing money as they do of earning money. This will a) discourage them from thinking that investing is a sure thing, and b) encourage wise spending.
While investing may not hold any interest for them at this point in their lives, it's important that they know such financial opportunities exist.
Most importantly, give them a head start
The money habits your children learn - and witness from mom and dad - will certainly carry over into adulthood. While you may be proud of the 12-year-old who saves enough to buy a $400 bike, you might be even prouder of the 22-year-old who can move into her first apartment without having to ask mom and dad for a loan, or the 32-year-old who can draw on his savings and investments to put a 30% downpayment on his first home. When those financial successes come, your son or daughter might even turn to you and say, "Thanks, I owe it all to you."
Over the past two years, the hardest-hit investors were those who didnt diversify and loaded up on technology stocks only to see their portfolios downsized by NASDAQs market fluctuations. The moral here?
Diversification is key.
You can be better off the broader array of investments. For instance? If youre looking for portfolio diversification stability and income, and youre in the upper federal income tax brackets, consider municipal bonds. They have quietly staged a comeback with a very respectable 11.5% return in 2000 to go with their positive return in 2001 as well.
Why are municipal bonds such a good opportunity now?
New-issue volume is up nearly 40% over last year and all signs point to this high volume continuing. And even more important, healthy long-term tax-free yields remain relatively unchanged this year. Meanwhile, comparable taxable bond yields have declined during the same time, so when you look at municipal bonds next to taxable bonds, select municipals are now a better value for the high tax bracketed investor.
Timing right for many investors.
And whats more the past decade of economic growth has only strengthened the financial positions of many municipal bond issuers. The Relative strength in the municipal sector seems unlikely to slow in the current economic climate.
What if you contrast municipal bonds to other types of bonds?
Despite credit downgrades in other bond markets, municipal bonds have fared well with upgrades exceeding downgrades by 3 to 1 in 2000*. And with inflation still in check, the Federal Reserve has considerable room to reduce short-term rates in order to give the economy a jolt. This pattern could reduce the risk of credit erosion for municipal bonds.
*Municipal Investor Monthly, March 2001
Advantages of Municipal Bonds.
That depends on what your investment objectives are. Even if tax-free income isnt a big consideration for you, individual municipal bonds offer you three other important benefits:
- Theyre safer. In fact, municipals are second only to obligations of the federal government for continuous payment, and have a much lower incidence of default than corporate bonds. Investors should be selective and focus on insured AAA municipals for added safety
- Theyre diversified. You can choose from a large inventory of Municipal bonds with a varity of maturities, ratings and coupon rates, as well as issuers.
- Theyre marketable. There is an active secondary market for municipal bonds that lets you sell your bonds at current market prices.
Still wondering if municipal bonds are for you?
Determine the yield youd need to earn on a comparable taxable investment. Since taxes change from year to year, you can use this simple formula:
Municipal Bond Yield = Taxable Equivalent Yield
100% - % of Tax Bracket
Or think of it this way. If you earned 5% on your municipal bond (the tax-exempt yield) and were in the 31% federal tax bracket, you need to earn 7.25% on your taxable investment.
SAFTEY OF MUNICIPAL BONDS
Tax free municiapl bonds offer very competitive yields compared to current CD's and money market funds on an after tax basis. Investors must remain selective with muni's a with other bonds as they are not all created equal nor are they safe.
Consider the $200 million in municipal development authority bonds backed by Kmart rental payments that have fallen into default because of the retail chain's bankruptcy. Or the United Airlines-backed bonds floated to expand facilities at O'Hare International Airport, which tanked after September 11. As a growing number of municipal bonds backed by specific revenue streams become distressed, some muni bond experts have begun to caution investors to stick to bonds backed by general municipal revenues.
Even general obligation bonds are not as straightforward as they used to be. Investors may be too overconfident in the companies that offer municipal bond guarantees. Over half of all municipal bonds are now backed by financial guarantees that confer AAA ratings, even when the cities, states or agencies that issue them are rated below AAA.
Investors must realize that they are private companies, not government agencies that are mandated to work in the public interest.
If the guarantors become unstable, the prices of the bonds they guarantee could collapse. Such an event would catch retail investors and many brokers alike by surprise. There are four companies that dominate the financial guarantee market. They are MBIA, Ambac Financial Group, Finance Security Assurance and Financial Guaranty Insurance (a unit of GE Capital). A bond issuer can buy a guarantee, also called a wrap, from any of these companies to raise their bond rating and reduce their borrowing costs. In return for an annual fee during the life of the bond, the financial guarantor, or wrapper, pledges to pay investors all regularly scheduled principal and interest payments if the issuer cannot meet its obligations.
The wrappers' stocks had a bumpy year in 2001. First, they were hit by the California utility crisis. MBIA, the largest of the financial guarantors measured by its insured portfolio, has a combined exposure of $1 billion to Southern California Edison Company and Pacific Gas & Electric. That's about 10 percent of the company's $10.1 billion in claim-paying resources. Then came September 11. MBIA's exposure to New York City is about $8 billion, and the company has an additional $15 billion in exposure to U.S. airports and airlines totaling more than two times its reserves. Ambac puts its exposure to U.S. airports at $6.5 billion.
Totaling those numbers doesn't make any sense, says Dick Weil, MBIA vice chairman. The way to look at our risk is to look at probability. Will people really stop using airports? He notes that the company's losses have historically been three basis points, or 0.03 percent, of its guaranteed portfolio. He adds that MBIA's legal rights to payment exceed that of other creditors. And even when MBIA must make claim payments, it is often reimbursed. This was the case after MBIA paid investor claims of $660,000 when Southern California Edison failed to make coupon payments on two of its insured bonds in January 2001. MBIA anticipates no losses because of either crisis.
Nonetheless, the terrorist attacks did trigger downgrades of several bonds within the insurers' portfolios. Additional downgrades are likely, though none have yet to be put on the watch list, says Jack Dorer, a senior vice president at Moody's. However, he adds: "Further deterioration in the airport bond sector, for example, could increase the risk profile of the guarantors' portfolios."
Nonetheless other trouble spots could emerge within their portfolios. Financial guarantors don't just specialize in municipal bonds anymore. They have diversified, now offering guarantees for more complicated structured corporate finance instruments and international debt. Smith says the risk of default of bonds in these new businesses is likely to be higher than in municipal bonds, where the default rate has been less than 0.5 percent over the past 40 years.
It wouldn't even take the bankruptcy of one of the financial guarantors to wreak havoc in the muni bond market. A simple downgrade to one notch below AAA would serve as a wake-up call for investors who currently assume that there is no risk in holding guaranteed municipal bonds. Such a sudden change in perception would possibly trigger a steep decline in bond prices.
Some advisors suggest that investors should apply the diversification rule to their muni bond portfolios just as they should not load up on bonds from any one issuer, their bonds should hold guarantees from a variety of wrappers.
Patrick Early, manager of municipal bond research at A.G. Edwards, says that if one financial guarantor finds itself in trouble, investors will suddenly question all guarantors, and all wrapped bond prices will fall. A downgrade would be a big psychological blow to the market, he says. The reason so many bonds trade so freely is because the insurers have homogenized the market. But a threat of a downgrade? I think that's a stretch.
In general most muni bonds are still sound investments for individual investors. It's just the prices paid by many investors may be inappropriate.
All investments carry some risk, the role of the market is to assign a price to that risk. Large institutional investors have long demanded a small discount for guaranteed municipal bonds relative to AAA municipals that do not require insurance to earn the top rating. The discount reflects the notion that any risk, no matter how small, should be reflected in a bond's price.
Many times individual investors are not always offered the same discount.
The first obligation of advisors is to make sure that their clients understand the risks involved in the bonds they buy. And their second obligation is to make sure their clients are compensated for these risks, however small.
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