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Answer:
During
the past two weeks, we've been running a series on
municipal bonds. Click HERE
to read the first of the two columns, and HERE
to read the second. We wind up our coverage today
with a discussion of municipal bond safety.
While
municipal bonds are not offered through BUYandHOLD,
you can trade them through our full-service affiliated
site Freedom
Investments.
The
Safety Issue
Like
corporate bonds, municipals are rated for safety --
which really means, how likely they are to default.
The ratings are done independently by Standard & Poor's
and Moody's. The safest bonds are rated AAA or Aaa.
Keep
in mind that the higher the rating the less interest
the bond issuer needs to pay to attract investors.
The opposite is also true: the highest interest rates
are paid on the riskiest bonds, known sometimes as
"junk bonds."
Before
purchasing a municipal bond, be sure you know its
rating. Stick with those rated A or above. As we mentioned
in a prior column, General Obligation Bonds are the
safest.
Unrated
Bonds
You
may run across bonds that are not rated. An unrated
bond is not necessarily high in risk. It may be unrated
because the municipality is so small or has such modest
debt that its bonds have never been rated.
If
you personally know the community and if it is well
run, you should consider adding its municipals to
your portfolio. But plan to hold them to maturity
as there probably is very little demand for them and
therefore a very small secondary market.
If
you know nothing about the issuer of an unrated bond,
move on.
Maturity
Date
In
general, the shorter the maturity, the lower the yield
and the greater the price stability. Unless you routinely
trade municipals, it is considered prudent to stick
with those with maturities of less than ten years.
Marketability
If
you have to sell your bonds before maturity, you want
there to be an active secondary market. The most salable
munis are general obligation bonds of state governments
and revenue bonds of large, well-known authorities.
Smaller issues (and unrated bonds) can be tough to
sell.
Call
Provision
Look
for bonds that have "call provision." Otherwise, if
your bond is called in before maturity you will have
to sell it and reinvest that money, probably at a
lower rate than you were earning. A bond with call
provision cannot be called for a certain number of
years.
Insured
Bonds
Although
it's rare for a municipal bond issuer to default,
it can happen. If you're a very conservative investor,
you can boost your safety level by purchasing insured
bonds.
To
insure its bonds, an issuer pays an insurance company
a premium. The insurance company in turn agrees to
pay the principal and interest to bondholders if the
issuer defaults. The policy cannot be canceled and
the insurance remains active over the lifetime of
the bond.
The
trade-off for such a high degree of safety is that
insured bonds pay slightly lower interest than comparable
uninsured bonds.
CAUTION:
Insurance does not protect you against market risks.
If interest rates go up, the value of your bond still
goes down.
$TIP:
Once a bond is insured, it is given a triple A rating
by Standard & Poor's and Moody's even if it originally
had a lower rating. So remember that if you are purchasing
a triple A-rated insured bond, it could be a lower
rated bond with insurance.
Puerto
Rican Municipal Bonds
The
bonds of the Commonwealth of Puerto Rico come with
two important advantages.
(1)
Their income is free from state, local and federal
taxes no matter where you live in the United States.
(2)
To date, Puerto Rico has never defaulted on a bond
issue.
You'll
find Puerto Rican bonds issued for electric power
plants, aqueduct and sewer services, public buildings,
highways, bridges and the like.
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