​

Financial Samurai

Slicing Through Money's Mysteries

  • About
  • Invest In Real Estate
  • Top Financial Products
    • Free Wealth Management
    • Negotiate A Severance
  • Buy This, Not That (Bestseller)

The Allure Of Zero Coupon Municipal Bonds: Low Risk, Decent Yields

Updated: 02/22/2023 by Financial Samurai 68 Comments

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 sizable 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 2023 And Beyond

I will be adding to my municipal bond portfolio over the next two years 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.

When it comes to generating passive income, building a municipal bond portfolio is one way to do it. For those of you who feel your income taxes are too high, this post should be of particular interest to you. 

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.

Municipal Bonds Spreadsheet Offering

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.

Historical Municipal Bond Performance In Rising Interest Rate Cycle

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
2023 Federal income tax brackets

Investing For The Long Run

Based on my history of investing, I LOVE locking money away for 5 – 10 years at a time. I’ve done so with my private equity investments, venture debt investments, CDs and all real estate holdings.

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.

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.

Bond Credit Quality Ratings Chart

Municipal Bond Default Rates

Municipal Bond Default Rates By Rating And Type

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.

Zero Coupon Bond Chart

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.

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.

Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore. 

Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the easiest way to gain real estate exposure. 

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 yield. If you have a lot more capital, you can build you own diversified real estate portfolio. 

Recommendation To Build Wealth

Grow your wealth is by signing up with Empower to track your finances for free. They are an award-winning online platform that aggregates all your financial accounts in one place. This way you can see where you can optimize your money and track your net worth. You can also analyze your portfolio for excess fees.

After you link all your accounts, use their Retirement Planning calculator. It pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. I’ve been using Empower (previously Personal Capital) since 2012. As a result, I have seen my net worth skyrocket during this time thanks to better money management.

Personal Capital Retirement Planner Tool
Are you on track? Sign up for free to plan for your retirement future
Tweet
Share
Pin
Flip
Share
Buy this not that instant bestseller Wall Street journal banner

Filed Under: Investments

Author Bio: I started Financial Samurai in 2009 to help people achieve financial freedom sooner. Financial Samurai is now one of the largest independently run personal finance sites with about one million visitors a month.

I spent 13 years working at Goldman Sachs and Credit Suisse. In 1999, I earned my BA from William & Mary and in 2006, I received my MBA from UC Berkeley.

In 2012, I left banking after negotiating a severance package worth over five years of living expenses. Today, I enjoy being a stay-at-home dad to two young children, playing tennis, and writing.

Order a hardcopy of my new WSJ bestselling book, Buy This, Not That: How To Spend Your Way To Wealth And Freedom. Not only will you build more wealth by reading my book, you’ll also make better choices when faced with some of life’s biggest decisions.

Current Recommendations:

1) Check out Fundrise, my favorite real estate investing platform. I’ve personally invested $810,000 in private real estate to take advantage of lower valuations and higher cap rates in the Sunbelt. Roughly $160,000 of my annual passive income comes from real estate. And passive income is the key to being free.

2) If you have debt and/or children, life insurance is a must. PolicyGenius is the easiest way to find affordable life insurance in minutes. My wife was able to double her life insurance coverage for less with PolicyGenius. I also just got a new affordable 20-year term policy with them.

Financial Samurai has a partnership with Fundrise and is an investor in private real estate. Financial Samurai earns a commission for each sign up at no cost to you. 

Subscribe To Private Newsletter

Comments

  1. scott says

    February 13, 2017 at 5:42 pm

    Very Interesting Article, I’d like to know how you find the zero coupon bond information, do you utilize a broker? Any books you would suggest? I’m in Oregon so I’m interested in zero coupon muni’s there.

    Thank you

    Reply
« Older Comments

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *


n

Top Product Reviews

  • Fundrise review (real estate investing)
  • Policygenius review (life insurance)
  • CIT Bank review (high interest savings and CDs)
  • NewRetirement review (retirement planning)
  • Empower review (free financial tools and wealth manager, previously Personal Capital)
  • How To Engineer Your Layoff (severance negotiation book)

Financial Samurai Featured In

Buy this not that Wall Street journal bestseller

Categories

  • Automobiles
  • Big Government
  • Budgeting & Savings
  • Career & Employment
  • Credit Cards
  • Credit Score
  • Debt
  • Education
  • Entrepreneurship
  • Family Finances
  • Gig Economy
  • Health & Fitness
  • Insurance
  • Investments
  • Mortgages
  • Most Popular
  • Motivation
  • Podcast
  • Product Reviews
  • Real Estate
  • Relationships
  • Retirement
  • San Francisco
  • Taxes
  • Travel
Buy this not that WSJ bestseller 728
  • Email
  • Facebook
  • RSS
  • Twitter
Copyright © 2009–2023 Financial Samurai · Read our disclosures

PRIVACY: We will never disclose or sell your email address or any of your data from this site. We do highly welcome posts and community interaction, and registering is simply part of the posting system.
DISCLAIMER: Financial Samurai exists to thought provoke and learn from the community. Your decisions are yours alone and we are in no way responsible for your actions. Stay on the righteous path and think long and hard before making any financial transaction! Disclosures