Zero coupon municipal bonds are a type of low-risk investment you should consider for the low-risk portion of your net worth. I've personally built a decent municipal bond portfolio to help generate more tax-efficient passive income.
If you buy your own state's municipal bond, you won't have to pay state or local income taxes. Nor do you have to pay federal income taxes. Therefore, if you are in a high federal income tax bracket and live in a high state income tax state, municipal bonds are relatively more attractive.
In this post I'd like to do the following:
- Explain how to read a bond offering table, including municipal bonds
- Discuss the differences between a regular municipal bond and a zero coupon municipal bond
- Highlight who should consider buying zero coupon municipal bonds
Municipal Bond Portfolio 2024 And Beyond
I will be adding to my municipal bond portfolio due to higher interest rates. As someone without a day job, I like having a steady stream of low-risk, tax-efficient income given I life in California.
I'm also buying Treasury bonds yielding over 5%. With Treasury bonds, you don't have to pay state or local income taxes either. With one-year Treasury bond yields at the highest since 2007, they are too attractive to pass up.
Further, it's always nice to protect massive gains since the bottom fell out in February 2009. As a retiree, cash flow is more important than net worth. It is the cash flow I need to stay retired and pay for our family's living expenses.
When it comes to generating passive income, building a municipal bond portfolio is one way to do it. For those of you who are in a high federal income tax bracket, municipal bonds should be the most attractive.
Reading A Municipal Bond Offer Chart
After sending an e-mail about my financial goals to my wealth manager, he sent me a list of specific California municipal bonds for me to consider. There's a lot to digest, so let me first explain each column and then highlight two examples.
CUSIP: CUSIP stands for Committee on Uniform Securities Identification Procedures. A CUSIP number identifies most financial instruments, including stocks of all registered U.S. and Canadian companies, commercial paper, and U.S. government and municipal bonds.
Offer Quantity: The figures are usually in 1,000's. In other words, 315 = 315,000 shares.
Issue: The description of the bond
Coupon: The yield at the beginning of the offering. A coupon of 5 means $5, or a 5% yield on $100 par.
Maturity: When the bond matures, stops paying a coupon and when you can get your principal back.
Moody rating: Moody is a rating agency for securities. The higher the rating, the lower the chance of default.
S&P rating: S&P is also a rating agency for securities.
First call: When the bond issuer can get back their money before maturity. If the first call is the same as maturity, there is no first call. Issuers may want to have a first call just in case interest rates go down so they can reissue at a lower rate.
Call price: If there is a first call, then the price stated is what you'll get back. $100 is the default issue price.
Offer price: Where the bond is trading now if you want to buy it. For the Agoura Hills bond issued at $100 X amount of years ago, you can buy it today for $121.566.
Offer yield: The coupon divided by the current offer price minus any loss you would get after holding to maturity.
Current yield: The coupon divided by the current offer price.
Offer Yield To Maturity (YTM): The annualized yield you would get if you held to maturity. YTM is also called Yield To Worst (YTW) if the bond is callable.
Example #1: Agoura Hills, Regular Municipal Bond
If you wanted to buy one Agoura Hills bond, it would cost you $121.566 per share. You would get a $5 coupon every year double taxation free (no federal income tax, no state income tax), for a yield of 4.11% ($5 / $121.566). Sounds good. If you decide to hold the bond until maturity, 6/1/2025, you will only get $100 of the $121.566 you invested back. Sounds bad. Therefore, your yield to maturity is really only about 2.2% once you account for the $21.566 loss.
Why would anybody want to buy such a bond? Nobody says you have to hold on to the bond until maturity. It is quite possible to collect a 4.11% double taxation free yield for one year and sell the bond at $121.566 or even higher if interest rates come back down. In other words, the principal value of a bond changes before maturity and there is a secondary market by which you can buy and sell your shares as noted in the Offer Quantity column.
Bond Investors Must Forecast Interest Rate Direction
As a bond investor, you are basically taking a view of where interest rates are going along the yield curve and the issuer's ability to pay the money promised.
If you're buying a muni bond, you've already decided that you want to invest on the lower end of the bond risk spectrum since default rates for munis are very low (see chart below). Within muni bonds, you can further select the highest rated bonds for even less risk.
A 2.2% yield to maturity for the Agoura Hills bond isn't very attractive. I want a yield that's at least above the 10-year yield, even though I don't have to pay taxes on the 2.2% yield. Psychologically, it also feels bad to pay $121.566 for a bond when it was issued at $100, albeit it years ago.
So what's the solution? A zero coupon bond.
Example #2: La Mesa Spring Valley California School District GO, Zero Coupon Bond
The La Mesa bond is a zero coupon bond that pays no coupon i.e. no income each year. In exchange, you can buy one La Mesa bond for only $73.573, a $26.427 discount to par value. When it matures on 8/1/2026, you get $100 for each share you buy, which comes out to a yield to maturity of 3.2%. The La Mesa bond is also a general obligation bond backed by taxes, which is safer than a revenue bond backed by the performance of the asset e.g. train fares.
A 3.2% yield to maturity is 1% higher than the Agoura Hills 2.2% yield to maturity. But be aware the La Mesa Bond matures one year later than the Agoura Hills bond. Given time is money, it's only logical for a longer term bond to pay a higher yield. Further, since you can't collect any coupon payments, you aren't able to reinvest the money for potentially greater gains.
So who would buy a zero coupon municipal bond on the secondary market that doesn't mature for almost 10 years and pays no interest? Me! And maybe even you.
Here's my profile that argues why buying zero coupon bonds in an overall bond portfolio is attractive:
- High federal income tax bracket (32% – 37%)
- Living in a high income tax state (10.3% – 12.8%)
- Total federal + state marginal income tax rate = 40%+
- State taxes will continue to go higher because California is a blue state
- Don't need to generate more income because I'm already living on less than my current passive income
- Don't plan to die within the next 10 years
- Plan to continue being in a high tax bracket for the rest of my life
- Already have large exposure to equities and want to lower risk to protect principal gains since the global financial crisis
- Plan to keep California as my home base for at least 10 years
Investing For The Long Run
The longer I'm invested in a particular asset, the more I tend to make. I dislike seeing the daily/weekly principal value fluctuations, which sometimes tempt me to sell too soon or buy too early. I'd rather spend a lot of time researching a particular investment, deploying capital and forgetting all about it until the money comes due.
My time is best spent making money via my business. I shouldn't try to time the market and pick investments. Give me a 5% gross annual gain each year and I'll be happy. My annual business income yield is multiple times greater.
Zero coupon bonds are more attractive than regular bonds due to a higher yield to maturity. If you can afford to not earn a coupon, then you may come out ahead if you hold until the end.
Just know that if you have to sell municipal bonds, you may have to take a large discount. The muni bond market is relatively illiquid, so the bid / ask spreads are wide.
One thing to note is that there may be a long term capital gains tax on the profits you make from your zero coupon municipal bond depending on what price you bought it compared the the original issue discount price. Here's an article that explains the tax consequences further.
Bond Credit Quality Rating Chart
Below is a great chart that highlights the three different rating agencies and the way they rank investments. Given every retiree's #1 objective is to not lose principal, I'm mostly focused on buying municipal bonds with a credit rating of A, Aa, Aaa, AA, and AAA. Just be aware that even credit agencies can get things wrong too.
Municipal Bond Default Rates
The default rate for A-rated municipal bonds is only 0.05%. By the time you get to Aaa, the top rated Moody's municipal bonds, the default rate drops to 0%.
It's up to you to decide how much risk you want to take. Studying the chart makes me comfortable buying some Baa rated municipal bonds in the portfolio with a 0.32% default rate in order to get a higher yield.
Zero Coupon Municipal Bond Offers
Here's the final snapshot after filtering out the best zero coupon municipal bond offerings from the main spreadsheet. The Folsom Cordova and Anaheim bonds look attractive, but I'd have to lock my money up for 13-14 years instead of my sweet spot range of 5-10 years.
The solution to investment uncertainty is to build a bond ladder just in case interest rates continue to rise. For example, if I invested $10,000 in each of the five zero coupon bond offerings above, I'll receive $13,591, $14,102, $14,760, $15,608, $16,588 in 2026, 2027, 2028, 2029, and 2030, respectively.
Build A Municipal Bond Ladder With Different Durations
If interest rates rise, I'll just buy more zero coupon bonds with higher YTMs in a ladder fashion again. All I've got to do is “survive” from now until 2026. Of course I will because I've got passive income and business income that's pretty sticky.
A total investment of $50,000 will turn into $74,649 by 2030. This assumes I don't reinvest a dime of the earlier maturing bonds. A $24,649 return ($24,649 / $50,000) is a respectable return, and even higher, tax adjusted. Not bad for a relatively low risk investment. It's very comforting to know exactly what you'll be getting in the future.
All these zero coupon yield to maturities were 0.5% – 0.85% lower right before the presidential election. It's the same for most zero coupon bonds. That's a nice $5,000 – $8,500 a year lift in tax free income on a $1,000,000 position. All five YTMs are also greater than my 2.375% and 2.5% mortgages as well. This doesn't even take into consideration the tax benefits.
It feels amazing to finally be able to build a double taxation free municipal bond portfolio now that yields are higher. Take advantage of higher interest rates by earning higher interest income.
Below is a bond yield table from Fidelity that highlights all different types of bonds by duration. The table updates every day. Toward the bottom, you can see three types of Municipals by investment grade. The higher the investment grade, the lower the yield. Usually, the longer the duration, the higher the yield.
Bonds Plus Investing With Real Estate
In addition to investing in bonds and municipal bonds, consider investing in real estate too. I consider real estate to be a type of bonds plus investing given the greater potential upside.
The combination of rising rents and rising capital values is a very powerful wealth-builder. In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms.
Best Private Real Estate Investing Platforms
Fundrise: A way for all investors to diversify into real estate through private funds with just $10. Fundrise has been around since 2012 and manages over $3.3 billion for 400,000+ investors.
The real estate platform invests primarily in residential and industrial properties in the Sunbelt, where valuations are cheaper and yields are higher. The spreading out of America is a long-term demographic trend. For most people, investing in a diversified fund is the way to go.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. These cities also have higher growth potential due to job growth and demographic trends.
If you are a real estate enthusiast with more time, you can build your own diversified real estate portfolio with CrowdStreet. However, before investing in each deal, make sure to do extensive due diligence on each sponsor. Understanding each sponsor's track record and experience is vital.
I've invested $810,000 in real estate crowdfunding so far. My goal is to diversify my expensive SF real estate holdings and earn more 100% passive income. I plan to continue dollar-cost investing into private real estate for the next decade.
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