Download Fixed Income Municipal Bonds

Private Wealth Management Products & Services | January, 2010
Fixed Income
Municipal Bonds
Tax-exempt municipal bonds are among the most popular types of investments in the market today. They offer a
wide range of benefits, including:
• Tax-free income
• Safety
• Predictable cash flow
• Diversification
• Liquidity
What Are Municipal Bonds?
Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities to raise money
for schools, highways, hospitals and sewer systems, as well as many other public projects. There are two basic types
of municipal securities:
• General Obligation Bonds – Principal and interest are secured by the full faith and credit of the issuer
and usually supported by the issuer’s limited or unlimited taxing power.
• Revenue Bonds – Principal and interest are secured by revenues from tolls, charges or rents paid by
users of the facility built with the proceeds of the bond issue. Some examples of projects financed by
revenue bonds include airports, toll roads, bridges, water and sewer systems, hospitals and low-income
housing.
When you invest in a municipal bond, you are lending money to an issuer who promises to pay a specified amount
of interest, known as the coupon, which is usually paid semiannually. The issuer also promises to return the principal
on a specific maturity date.
How Safe are Municipal Bonds?
When purchasing bonds, an investor’s primary concern should be the issuer’s ability to meet its financial obligations.
Historically, municipal bonds have been one of the safest investments available, second only to U.S. Treasury
obligations. One way to evaluate an issuer is to examine its credit rating. Two of the primary bond rating agencies
are Moody’s and Standard and Poor’s. Bond ratings are important because they reflect a professional assessment of
the issuer’s ability to repay its debt. The rating symbols of the two agencies are defined as follows:
Credit Risk
Prime
Excellent
Upper Medium
Lower Medium
Speculative
Very Speculative
Default
Moody’s
Aaa
Aa
A
Baa
Ba
B, Caa
Ca, C
Standard & Poor’s
AAA
AA
A
BBB
BB
B, CCC, CC
D
©2009 Robert W. Baird & Co. Incorporated. Member NYSE & SIPC.
Robert W. Baird & Co. 777 East Wisconsin Avenue, Milwaukee, Wisconsin 53202. 1-800-RW-BAIRD. www.rwbaird.com
First Use: 01/2010
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Municipal Bonds, continued.
Credit ratings should not be the sole basis for any investment decision. The ratings cannot, for example, take into
account market trends or unforeseen natural disasters.
In addition to their stand-alone creditworthiness, municipal bonds may be insured by outside agencies. These
insurers guarantee that they will pay bondholders their principal and interest if the issuer defaults. Some of the
larger and more well-known municipal bond insurers are Municipal Bond Insurance Association (MBIA), American
Municipal Bond Assurance Corporation (AMBAC) and Financial Guaranty Insurance Company (FGIC). Insurance
does not eliminate market risk and is limited to the strength and credit quality of the issuer.
Tax Exemption
Under present federal income tax law, the interest income earned from investing in municipal bonds is exempt from
federal income taxes. If an investor is subject to the Alternative Minimum Tax (AMT), interest income from certain
municipal securities must be included in calculating the tax. In most states, interest income from securities issued by
governmental entities within the state is also exempt from state and local taxes for residents of that state. In
addition, interest income from securities issued by U.S. territories, such as Puerto Rico, is exempt from federal, state
and local taxes in all 50 states.
Taxable Equivalent Yield
One of the best ways to appreciate the tax-exempt advantage of a municipal security is to compare it to a similar
taxable investment. Municipal bonds may not be appropriate for all investors, especially those in lower tax brackets.
To determine if a municipal bond investment is suitable, you can use a figure called the taxable equivalent yield to
calculate how much you would need to earn on a taxable bond to equal what you are earning on a municipal bond.
Taxable equivalent yield is calculated as follows:
Taxable Equivalent Yield = Tax-free yield
1 - Tax Rate
Using this formula, calculate the return received on the taxable bond after federal income taxes have been deducted,
then compare that to the yield earned on the tax-exempt bond. If it is less than the tax-exempt yield, then the
municipal bond would be the better investment. It would be an even better investment if you accounted for state
and local income taxes when calculating the returns on the taxable bond.
Taxable Municipal Bonds
Not all municipal bonds offer income that is exempt from both federal and state taxes. A separate market of
municipal issues that are taxable at the federal level still offer a state tax exemption on interest paid to residents of
the state of issuance. Taxable municipal bonds exist because the federal government does not subsidize the
financing of certain activities that do not provide a significant benefit to the public. Some examples would be
investor-led housing issues, local sports facilities and borrowing to replenish a municipality’s under-funded pension
plan.
Diversification
Investors can diversify their bond holdings by choosing from a wide range of maturity dates, credit quality,
geographic locations, issuers and types of bonds. This allows the bondholder to have his or her assets allocated over
various sectors of the market. Municipal bond investors may also have the opportunity to invest locally in projects
taking place in their own communities.
©2009 Robert W. Baird & Co. Incorporated. Member NYSE & SIPC.
Robert W. Baird & Co. 777 East Wisconsin Avenue, Milwaukee, Wisconsin 53202. 1-800-RW-BAIRD. www.rwbaird.com
First Use: 01/2010
Page 2 of 3
Municipal Bonds, continued.
Liquidity/Secondary Market
Holders of municipal securities can sell their bonds in an active secondary market through a dealer firm that is
registered to buy and sell municipal securities. Municipal bonds are bought and sold in the over-the-counter market.
It is important to understand that during the life of a bond, the market price changes as market conditions change.
If you sell your municipal bonds prior to maturity, you will receive the current market price, which may be more or
less than your original cost, and may generate gains or losses.
Interest Rate Considerations
An investor in municipal bonds should also understand how the direction of interest rates may affect the value of
his or her bond holdings. Prices increase when interest rates decline, and prices decline when interest rate rise as
explained below:
• When interest rates fall, new issues come to market with lower yields than older securities, making older
securities worth more; therefore the increase in price.
• When interest rate rise, new issues come to market with higher yields than older securities, make the older
ones worth less; therefore the decline in price.
Call Features
Many bond issues allow the issuer to call, or retire, all or a portion of the bonds at a premium or at par, before
maturity. When buying bonds, it is important to understand and be aware of all potential redemption provisions.
Your Financial Advisor will quote the yield to call and the yield to maturity when the yield to call is lower. This will
generally occur when the bonds are trading at a price above the initial call price.
Are Municipal Bonds For You?
To find out if Municipal Bonds fit into your overall investment strategy, call your Baird Financial Advisor or contact
the Baird office nearest you.
*Please visit emma.msrb.org for more information about municipal securities.
©2009 Robert W. Baird & Co. Incorporated. Member NYSE & SIPC.
Robert W. Baird & Co. 777 East Wisconsin Avenue, Milwaukee, Wisconsin 53202. 1-800-RW-BAIRD. www.rwbaird.com
First Use: 01/2010
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