If you're thinking about holding individual municipal bonds as a safe and liquid source of funds, think twice. Owning highly-rated municipal bonds is low risk. However, selling individual municipal bonds can be incredibly expensive and cumbersome.
Unlike stocks, which now have $0 trading fees and ample liquidity, municipal bonds have a much less liquid market. As a result, if you ever want to sell municipal bonds, you might have to sell them for way below market value.
The key takeaway from this post is that if you plan to invest in individual municipal bonds for tax-efficient passive income, you should plan to hold them to maturity. Do not count on individual municipal bonds as an easy source of liquidity if an emergency comes up or if you want to buy a large ticket item like a house.
Please note I am differentiating between owning individual municipal bonds and owning shares in a bond fund, which usually has much more liquidity, but no maturity date.
Counting On Municipal Bond Proceeds For A House Down Payment
The closer you are to buying a house, the greater the percentage of your down payment should be in cash and low-risk investments such as Treasury bills. When you find the home you want to buy, you generally need to put down at least 20% to be competitive.
Given the high price of homes these days, 20% down is usually a lot of money. It would be unwise to gamble your down payment in the stock market given its volatility. The more you have to stretch to come up with an acceptable down payment, the more conservative you should be with your house down payment investments.
Some of you might have considered investing in individual municipal bonds instead of cash or Treasuries due to their tax advantage. You don't have to pay federal or state income tax if you are buying municipal bonds issued by your state of residence. Therefore, the higher your marginal tax rate, the more attractive the asset class.
However, despite a potential higher net yield, I wouldn't park your down payment in individual municipal bonds. You might not be able to sell them because there may not be a market for them. And if you do sell them, you will likely have to sell them at a steep discount.
Bond Table Sorted By Duration
Before I share with you my municipal bond-selling experience, let me quickly share why someone might prefer owning munis instead of Treasuries or other bonds. Take a look at this bond table below.
You can get a two-year Treasury bond yielding 4.91% and a two-year Aaa-rated municipal bond yielding 3.98%. If your marginal income tax rate is 37%, the net yield on your Treasury bond is 3.09% since you pay federal income tax on bond income, but not state income tax.
Given 3.09% is lower than 3.98%, a person in the 37% marginal income tax bracket may prefer to own a two-year Aaa-rated municipal bond instead. In this example, the breakeven point is if you are in the 19% marginal income tax bracket, which there's currently no such thing.
The marginal income tax rate jumps from 12% to 22%. Therefore, anybody paying a 22% marginal income tax rate or higher would benefit more from buying the municipal bond if they hold to maturity.
Holding individual bonds to maturity protects you from principal loss in case interest rates rise during the holding period.
Since early 2022, all types of bonds have gotten pummeled since inflation and interest rates have surged higher. Therefore, if you have to sell bonds now it is not an optimal time.
First Unanticipated Problem Holding Municipal Bonds
When I submitted an offer with contingencies for a house, I assumed around $400,000 of the proceeds would come from municipal bonds I have held for over six years. Although I would take a loss on most of the bonds, I needed some losses to offset some gains I would have from selling stocks.
What I didn't anticipate was not being able to sell about $200,000 out of the $300,000 municipal bonds I held at my Citibank brokerage account! My wealth manager tried for two weeks to sell a couple of my large municipal bond holdings to no avail. There were simply no bids, even at lower and lower prices.
Uh oh. How the heck was I going to come up with the $200,000 shortfall in this account?
Reason #1 for not counting on individual municipal bonds for liquidity. You literally might not be able to sell them!
If you have no other sources of funds to come up with your house down payment, you might fall out of contract. You might even lose your earnest money deposit if you release financing contingencies before realizing you can't liquidate your municipal bonds. Beware.
Second Unanticipated Problem Holding Municipal Bonds
I then went to my Fidelity brokerage account, where I also held some municipal bonds. Anticipating I would have a difficult time selling my municipal bonds here as well, I gave the rep a call to see what he could do.
He walked me through the process of selling a municipal bond, which required multiple steps. The first step was to click the individual bond holding, then click the Sell button. Then I had to scroll down to get a Bid Request.
The Bid Request was not instantaneous. It takes the system about one hour to determine whether there is demand for the number of municipal bonds I want to sell. I would get notified either by text message, e-mail, or both.
This was inconvenient because I so happened to be at the beach with my daughter. In addition, the Fidelity mobile app didn't have the functionality to sell municipal bonds. I had to call Fidelity back once I got my bid request alert.
If I didn't review and accept the bid requests within ~5 minutes after they came, they would expire. I would then have to go through the entire process again. What a pain in the a$$!
Example Of Muni Bond Bid Request Results
Below is a snapshot of my Bid Requests, most of which expired because I wasn't paying immediate attention an hour later.
Hence, my second unanticipated surprise from trying to sell individual municipal bonds was that once I found a brokerage that could sell them, the process was extremely cumbersome. I had to dedicate at least an hour of my time to sell a municipal bond compared to selling a stock instantaneously through a mobile app.
Reason #2 for not counting on individual municipal bonds for liquidity. The process is not instantaneous.
Final Unanticipated Surprise Of Selling Municipal Bonds
I never planned to sell my municipal bond holdings before maturity, let alone during the worst bond bear market in recent history. However, when my dream house reappeared a year later at a lower price, I decided to go for it. The discount I'd get from the house would more than cover the loss from selling the bonds.
When I finally got to review my bid requests, I was shocked by how much lower the bid price was compared to the market price. We are talking a bid / ask spread ranging between 1% – 4%, with the average hovering around 2.85%.
In other words, if I wanted to sell $10,000 worth of municipal bonds, I had to pay between $100 – $400 or accept between $100 – $400 less. At first, I held my nose and sold some bonds because I was initially so relieved to find out I could actually sell some of my bonds through Fidelity.
But then I took a step back and paused. Paying the higher end of 1% – 4% to sell my municipal bonds felt like highway robbery! I would rather just hold them to maturity and find other sources of capital that didn't have such egregious selling costs.
Below is an example of a bid price of $59.801 for a zero-coupon municipal bond currently trading at $61.643. The difference is $1.812 for a spread/fee of 2.94%. Not reasonable!
Although, in a future municipal bond sale, I was able to get a very tight bid ask spread (see below). So a lot of the spread depends on the type of municipal bond and the interest rate environment. If you see a big bid ask spread, you may want to wait and try selling again at a later time.
Reason #3 for not counting on individual municipal bonds for liquidity. If you have to sell, you may have to sell at a steep discount.
Some Brokerage Houses Are Better Than Others
It turns out that Citibank isn't a great platform to sell municipal bonds. Not only is its trading platform technology inferior to Fidelity's, it also somehow can't tap the same pool of municipal bond liquidity Fidelity can.
Given I couldn't sell $200,000 worth of municipal bonds at Citibank, I realized I could simply transfer my Citibank portfolio over to Fidelity. This process would take about 7-10 days total. I've done it before.
Given I have a long escrow period with contingencies, waiting 7-10 days to port my Citibank portfolio over wasn't a big deal. But if you need the liquidity sooner, then this solution won't work. Because after you sell a municipal bond, you won't get the proceeds for two days (T+2). Hence, plan ahead.
In retrospect, I'm thankful I couldn't sell $200,000 worth of municipal bonds at Citibank. Selling them would have cost me $2,000 – $8,000.
I also don't plan to sell $200,000 worth of municipal bonds in my Fidelity portfolio either due to the fees. In fact, I want to build a larger bond portfolio to lock in higher interest rates for more passive income.
Finding New Capital To Make Up For The Shortfall
How will I come up with the capital shortfall if I don't sell my municipal bonds?
One idea is to ask for a bridge loan paying a 5.5% interest rate to the Bank of Mom & Dad. But I'm uncomfortable asking for more money because I'm supposed to be helping them, not borrowing from them.
Another source of funds could come from my rollover IRA. Supposedly, I'm able to use funds from my IRA so long as I return the funds within 60 days. This is called the 60-day rollover rule from the IRS website. Luckily, my rollover IRA has enough funds to cover the entire shortfall. The problem with this solution is paying back the money within 60 days.
Another source of funds is to get a job or do some consulting work. I'll couple this work with cutting our expenses. But these activities won't even make up for 10% of the money that's needed since I only have a month left. But I should try anyway.
The final source of funds is to ask my wife to tap into her taxable retirement portfolio. We buy everything together. But we also earmark certain funds specifically for retirement to stay disciplined. Otherwise, we might be tempted to spend too much money on too many luxuries we don't need. Such as this nicer house!
We don't plan to apply for a mortgage. The high interest rates, time it takes, and cost to apply is not worth it. I’m happy turning funny money stocks into an home after the rebound.
Don't Count On Your Municipal Bonds To Pay For A House
In conclusion, don't think of municipal bonds as a liquid alternative to cash. It is not due to its high selling fees and difficulty of selling. The longer the duration of the municipal bond, the more value it will lose if interest rates go up.
Hence, if you want to park your house down payment in bonds, buy 3-month or 6-month Treasury bills. If you do, the impact of higher rates, if they happen during your holding period, will be negligible. Further, the Treasury bond market is highly liquid, unlike the municipal bond market.
When I used to work in finance, bond traders were some of the wealthiest employees at my firm. Now I have a clear understanding why. The fixed income bid-ask spreads are so large, bond traders are able to make a killing if they can successfully meet market demands.
If you plan to invest in individual municipal bonds, hold them to maturity. Only if interest rates plummet and the value of your bonds skyrocket, should you consider selling them beforehand.
Related: Should I Buy Bonds To Build Wealth? Rich People Don't
Reader Questions and Recommendations
Have you ever had to sell an individual bond due to liquidity needs? If so, why? If you are an experienced bond investor, what are some other things we should be aware about when buying and selling bonds, not just municipal bonds? Anybody buying bonds now to take advantage of high interest rates?
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All about who the broker is and if they make markets in these bonds.
I invest in muni for term, I stay in the more liquid issues and have a sub account with Lord Abbett who gives great execution.
I also work in FI so I know if the big liquidity spreads across the universe and eyes wide open at my entry points across muni and other fixed income/structured Credit instruments.
Sorry to hear about your experience.
Did I hear u are asking your parent for loan? U don’t have other liquidity ?
How big are your bid ask spreads?
Borrowing from parents is one option. Here’s another option.
https://www.financialsamurai.com/60-day-rollover-rule-to-borrow-from-your-retirement-plans/
Munis are prob 25-75bps depending on factors like type of bond, maturity, size of issue, etc…
I don’t sit on that desk but have a pretty good idea.
Typical bonds and BSLs are usually 25 or so.
Do u have a liquidity access line to use for circumstances like this?
Good to know. Makes me feel even better about not selling then. I’ve seen some 90 bps spreads, but not less so far.
I don’t have a liquidity access line. But I’ll find a way to come up with the funds. It’s been a fun challenge.
I’ll say the LAL has really provided value to me – including terming it out when rates was low and using it for positive carry.
Best of luck Sam u def take more funding risk that I feel comfortable with!
Thanks. What would be a more appropriate funding risk in your view? There seems to be a number of different ways to go about it give people have various net worths, income, expenses, and earnings potential.
I think if i could potentially have a hole in my liquidity, I would invest in an instrument that either could have a real market value move (which any long term fixed income asset could) or liquidity squeeze (all things but cash and US govt).
I personally don’t feel comfortable with having to plug the home with accounts for a different states purpose.
Not saying that’s best for you, I’m more conservative in my liquidity and ability to have that liquidity for forward commitments and opportunistic investing.
Even in my most bullish case I have 5-10 percent on cash.
I do have a strong income and strong NW but work in a field u know to be volatile.
I think a house deposit should be cash, Money market or soemthing else short duration with no ability to “surprise” with an interest rate, credit, or otherwise shock. And def don’t want to hit tax advantaged accounts. It’s why I set up my LAL back in 2018 so I would never ever have to worry about liquidity in a crunch, including using it to buy a house (which I did) and getting a mortgage on the backend (which I did)
But I understand your logic and used to run very aggressive with my liquidity. However I’ve realized my best investments have been when crisis hits (seems every few years lately) so I like to have the cash and not dollar cost average.
“ But I understand your logic and used to run very aggressive with my liquidity. ”
To clarify, does that mean having less liquidity?
For me, my liquidity is somewhat of an artificial constraint. I don’t need to buy this house or sell XYZ securities. If I want to come up with more funds, for example, I would just sell more stocks. So it’s really just shooting for the ideal portfolio and net worth composition.
I’m not a fan of using lines of credit to borrow money at my age. I’m trying to decumulate, not accumulate more. After all, I left work in 2012 because I had enough back then.
How old are you and where are you on your financial independence journey?
I’ll always take leverage when it makes sense and it’s not required for me to make my return.
Long term, non callable leverage at a fixed rate is valuable (just like mortgages obviously which is tied to that house and non-recourse). I don’t like selling assets and taking the tax hit – rather use my LAL as needed and manage my tax positions.
I would say this is a very common strategy especially if the funds RE being used not for consumption.
I use my LAL a lot for funding my capital calls and not having to have cash sitting in the sideline or having to sell position in an inefficient way if capital is called at the worst of times.
I’m regards to liquidity, used to have less of it and more in equity or Long duration exposure. As I have gotten older (late 40s) I have gotten wiser (for my risk tolerance and investment opportunity set) with how I view liquidity. I do not imply what I do works for anyone else or vice versa.
Very interesting post! I don’t have any muni bonds. I’ll plan to hold until maturity if I get some. Good post. I purchased some 6 month Treasury bonds this year. That seems like the simpler way to go for most people.
Part of the liquidity problem at Citi was probably because they don’t have a huge mutual fund/ETF management division. My family has never had any issue at JPM selling any of our holdings. It’s a lot easier to sell them when there is a guaranteed buyer a few cubicles down.
Yes, that’s for sure. How large were the bid / ask spreads though when you sold at JPM?
Sam –
I guess I know nothing about bonds. *sigh*
Looking at the “Bond Table Sorted By Duration”, for a triple A rated municipal bond, why would a 3 month duration (@3.80%) earn a higher interest rate than a 6 month (@3.63%) or 1 year (@3.58%) duration? I always assumed when it came to bonds (and CDs), longer durations earned higher rates than shorter durations. Is there something about the various durations that make them either more or less appealing to the bond issuer? Is there perhaps less demand for certain bond durations, making those durations harder for the bond issuer to market / sell? It just doesn’t make sense to me.
Thank you in advance for enlightening me!
Hi Kat,
It’s because yield curve is inverted after 11 Fed rate hikes. It is an ominous sign for the economy as the government soaks up liquidity and long term lending slows.
See: https://www.financialsamurai.com/understanding-the-yield-curve-a-recession-predictor/
Sam
Thanks Sam,
I’m learning the same lesson the hard way. I’m even having problems selling bonds that I had bought out of Fidelitys inventory (individual bond issuance that they normally keep fairly liquid). The biggest issue has been in the longer maturities. I had bought corporates. Had I not bought issues that they make a market in, it would have been even worse I suspect. The good thing I find about learning lessons the hard way -is that I tend to remember the lessons…
Another episode of “Cash is King,”eh?
I own a couple CA munis that I bought roughly 5 years ago. I don’t remember thinking about the maturity date when I bought them. I was just looking at the rating. Your post made me curious what the maturity dates are because I had no idea they can be so hard to sell either. Looks like mine mature in 2035, wow! I’m glad I only have a small percentage in them. The rest of my bond exposure is in bond ETFs.