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Trading Muni Bonds with a Small Account

Trading Muni Bonds with a Small Account

Municipal bonds, or munis, are a tax advantaged investment. These are bonds issued by municipalities including cities, towns and states. Other government entities, like school boards or industrial improvement board, also issue the bonds. Munis can also be issued by public utilities in some cases.

They are tax advantaged because the interest is generally free from federal income taxes. This isn’t always the case and you should always consult a tax adviser for specific guidance related to your personal situation.

Often, states will also consider the interest income to be tax free for bonds issued by entities within the state. Cities with income taxes may adopt the same policy. This could lead to some bonds being “triple tax free” for taxpayers in locations like New York City.

The tax advantage is one of the most important features of these bonds and investors will generally accept a lower interest rate because of the tax advantage. When considering an investment in munis, the investor will need to find the taxable equivalent yield (or TEY).

The TEY is equal to the yield on the municipal bond divided by 1 minus the investor’s federal marginal tax rate, which is the highest rate paid by the investor. This is the investor’s tax bracket.

For example, consider a municipal bond with a tax free yield of 4.5%, and an investor who is in the 35% federal tax bracket. The TEY would be 6.92% in this example, (0.045 / (1-0.35) = 6.92%). This means the investor would need to earn 6.92% on a taxable bond to get the same return as a 4.5%.

Because they will usually pay less interest than corporate bonds or Treasury securities, investors in lower tax brackets often ignore municipals.

That can be a mistake, especially when the muni bond market is more volatile than usual.

Right Now, Volatility is Higher than Average

Volatility is high in the muni bond market largely because of Puerto Rico. The recent price action, as shown in the chart below, is unprecedented. Muni bonds usually move a few percent in a year. These bonds dropped more than 40% a month.

Source: Bloomberg

As noted by one analyst, “the island’s $74 billion pile of bonds has been a slow moving train wreck for years, pocked with threats, negotiations, promises and now, finally, what is essentially bankruptcy court.” Then, a hurricane destroyed much of the island’s infrastructure and the problem grew worse.

It would be tempting to write down Puerto Rico’s debt and allow the island to focus solely on rebuilding. However, Puerto Rico is not the only slow moving train wreck. The muni market consists of about $3.8 trillion in bonds and has grown rapidly in recent years.

Source: Bloomberg

Municipalities will have to refinance debt as it becomes due, much like the federal government rolls over Treasury securities as they come due. Municipalities will also have to issue new debt to fund new liabilities, like pension funds and capital projects like stadiums.

A Large Market, But Not Always an Accessible Market

As noted, munis are a large market with almost $4 trillion worth of securities available to investors. This total market is broken down to an estimated 1.5 million different types of muni bonds. Trading requires finding the right bond, and that search can be difficult for a few reasons unique to the market.

Trading is expensive. One study estimated that, between 2005 and 2013, the muni bond market’s pricing inefficiencies likely cost investors ‘substantially’ more than $10 billion. “Pricing inefficiencies” means that the market is not actively traded and its price quotes are not constantly updated as they are in stocks or options.

Without access to reliable pricing data, many retail investors end up overpaying when they buy. They then also receive a lower price when they sell, potentially doubling the cost of inefficient pricing.

There is also the problem of liquidity. Many muni bonds go days or weeks without a single trade compared to high-volume trading in the equity markets. This lack of liquidity makes it difficult to determine a fair market price for buying or selling.

There is also a high minimum investment to ensure a degree of safety. Some firms recommend a minimum account size of $500,000 in order to sufficiently diversify a portfolio. Others recommend at least $200,000 which is still a large investment.

Trading With a Small Account

For investors with a small account size, municipal bonds are often ignored. This can make sense given that the market is so diverse that significant effort is needed to research the best investment options for a particular investor.

Smaller investors will also not usually benefit from the tax breaks the bonds offer. This can be one of the reasons the market is not widely followed by individuals.

To help individuals who can benefit from the tax breaks, there are a number of mutual funds that offer alternatives. These funds are often focused on a state to maximize the tax breaks for an individual, providing double tax free investment income that is exempt from state and federal taxes.

There are also closed end funds, which are similar to mutual funds but trade like stocks. And, in recent years there have been exchange traded funds (ETFs) created to provide exposure to municipal bonds. There are even options available on the ETFs, providing trading opportunities for small investors.

Although options make the market accessible to small investors, the market is not always worth trading. That is because the ETFs have low volatility. The chart of one ETF, iShares National Muni Bond ETF (NYSE: MUB), is shown below. At the bottom of the chart is the zig zag indicator.

The zig zag indicator measures only price changes of a certain percentage. It is set to 10% in the chart above and shows munis have declined by 10% just once since 2008. iShares 20+ Year Treasury Bond ETF (NYSE: TLT), an ETF tracking government bonds has suffered seven 10% declines in that same time.

Despite the low volatility, munis could be set to see increased volatility. There are several factors pointing to higher volatility.

First is Puerto Rico, which is the latest large municipality to suffer problems with repayment. Detroit declared bankruptcy along with several other large cities. Experts believe more municipalities will face bankruptcy in the coming years.

Then, there is the likelihood of higher rates. The Federal Reserve is set to increase rates and higher rates will lower the prices of outstanding bonds.

A Specific Trading Strategy for MUB

After an extended bull market, it seems likely MUB will pull back. This sets up a potential trade.

Historically, MUB trades with low volatility. This means options are cheap. That implies there is little upside potential in selling options.

To benefit from an expected down trend, put options could be bought. Again, the options are cheap because volatility is low and the long term options are affordable.

The February 2018 $110 put on MUB can be bought for about $110. This option is trading at about $1.10 and each contract covers 100 shares.

If munis fall in price, as seems likely given growing crises and higher rates, MUB should fall. A long overdue 10% decline could lead to a triple digit gain in the put options.

These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.