The Allure Of Zero Coupon Municipal Bonds

Zero coupon municipal bonds

How can you resist?

In this post I’d like to do the following:

* Explain how to read a bond offering table

* Discuss the differences between a regular municipal bond and a zero coupon municipal bond

* Highlight who should consider buying zero coupon municipal bonds

I’m currently laser focused on building a significant municipal bond portfolio over the next three to four years due to higher interest rates, potentially higher taxes for middle income earners, and a world where there may be more geopolitical uncertainty. Further, I feel it’s a good idea to protect the ~200% equity gain since the bottom fell out in February 2009.

I’ve spent a lot of time figuring out how to slice my income below a 33% marginal federal tax bracket (<$112,500 for individuals, <$225,000 for married couples under the proposed Trump tax plan) and I just can’t make it work without killing a lot of golden geese. Therefore, whether my marginal federal tax bracket is 33% or goodness forbid, 39.6%, the percentage is too high for my liking, especially when you add on 10.3% – 11.3% California state tax and another 7.65% – 15.3% FICA tax.

For those of you who also feel your income taxes are too high and don’t need additional income, this post should be of particular interest to you. 

Reading A Municipal Bond Offer Chart

After sending an e-mail about my latest 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%.

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.

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, 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.

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 collect any coupon payments, you aren’t able to reinvest the money for potentially greater gains.

So who would buy a zero coupon bond 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 bond in an overall bond portfolio is attractive:

* High federal income tax bracket (33% – 39.6%)

* Living in a high income tax state (10.3% – 11.3%)

* Total federal + state marginal income tax rate = 43.3% – 50.9%

* 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 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

* Happy to help support my own economy

* Plan keep California as my home base for at least 15 years

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, 7-year 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 and not by trying to overly time the market and pick investments. Give me a 4% gross annual gain each year and I’ll be happy because my annual business income yield is multiple times greater.

Related: Ranking The Best Passive Income Streams

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. All I’ve got to do is “survive” from now until 2026, which 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, assuming I don’t reinvest a dime of the earlier maturing bonds. A $24,649 return ($24,649 / $50,000) is a respectable 49% double taxation free return, or a 81.7% gross return based on a 40% marginal federal and state tax rate. Not bad for a relatively low risk investment.

Oh, and in case you’re wondering, 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, without taking 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. Yes, borrowing costs have increased, taxes may be going up for millions, and oil prices are starting to rebound after the OPEC supply cut, but if you have cash to deploy and own assets, you should be sitting pretty!

Readers, anybody buying zero coupon municipal bonds? What are some types of bonds you’ve bought? Are you gearing up to build a municipal bond portfolio like I have after the sell-off? What am I missing from this analysis so I can add to the post? What are your thoughts on General Obligation bonds backed by taxes versus Revenue bonds backed by the entities revenue?