Tips for Building a Muni Bond Ladder

What is the best way for a high-worth investor to set up a municipal bond ladder, say with $5 million? How long should it be; how many rungs should it have; should it have a combination of premium, discount and par bonds; what about callability, credit quality and the alternative minimum tax? How should I time my purchases? What are the merits of buying new issues vs. secondary-market issues, and how do you go about buying new issues?

-- Jeremy Bennett

Jeremy,

Holy duration, Batman!

That's a wide array of bond investing topics, any of which could fill a column and many of which already have.

I'll try to lay out a road map here, but let me start by saying that if you've got $5 million to invest in munis, I think you should get professional help doing it, either from a full-service broker or a major discount broker like Charles Schwab or Fidelity. That's what I would do, and I've racked up five years on this beat (though some of my colleagues think that certifies me as crazy).

With $5 million to spend, you almost definitely want to buy individual bonds rather than bond mutual funds. A 1999 study concluded that investors with at least $50,000 to invest in bonds are probably better off buying individual bonds than shares of bond mutual funds, which claim a percentage of fund assets each year to cover expenses. (See the Sept. 10, 1999, Fixed-Income Forum for more on this.) And with $5 million to commit to muni bonds, you shouldn't have any trouble getting a broker to pay attention to you. Provided that you can find someone you trust, there's no reason not to take advantage of expertise.

Building a Bond Ladder

OK, let's define "bond ladder" for readers who aren't familiar with it. You build a bond ladder by buying bonds with staggered maturity dates. If all your bonds mature around the same time, you run the risk that interest rates will be low at that time, an unappealing prospect if you want to buy new bonds to replace the maturing ones. By constructing a ladder, you are diversified against that risk.

A ladder can be as simple as this:

One bond maturing in one year

One bond maturing in two years

One bond maturing in three years

One bond maturing in four years

One bond maturing in five years.

After one year, your shortest bond will mature and you will be left with:

One bond maturing in one year

One bond maturing in two years

One bond maturing in three years

One bond maturing in four years.

To maintain the ladder, you would take the proceeds from your maturing bond and use them to buy a new bond maturing in five years.

No Wrong Answers

For some of your questions there are no wrong answers. How long should your ladder be and how many rungs should it have? That depends entirely on your situation and your tolerance for risk.

Obviously, as an investor you want to take as little risk as possible with your money. In bonds, that means sticking with high-quality, short-maturity issues, which maintain their value more reliably than low-quality and long-maturity issues. But if your objective is to earn a high amount of tax-free income, a low-risk strategy might not get you there. You might have to consider riskier bonds, which offer higher yields but are more likely to experience large price changes.

Still, two general points can be made regarding the structure of your ladder. First, muni market professionals generally agree that it's best to stick with bonds that mature in 20 years or less. The extra yield you get from longer bonds isn't sufficient compensation for the extra volatility, they feel.

Second, while diversifying your portfolio with many different bonds will give you one kind of comfort -- protection from any one issuer's problems -- buying larger lots of fewer bonds will give you another kind: protection from illiquidity. The larger the quantity of bonds you buy, the lower the price you should pay in the first place and the higher the price you should be offered if you ever want to sell them. Muni market professionals generally counsel against buying fewer than 25 bonds at a time ($25,000 face value). Ideally, you would buy round lots of 1000 bonds ($1 million face value), but plenty of individual investors buy smaller lots for more diversification.

Other Considerations

Beyond the basic structure of your ladder (how long, how many different bonds), here's a list of things you should consider before you put one together.

Credit quality: Muni market pros say the best value is in high-quality bonds -- triple-A-rated insured bonds in particular. A large and growing supply of insured bonds keeps them relatively cheap. That is to say, their yields aren't very much lower than lower-quality bond yields. Plus you get to sleep at night.

Callability: Municipal bonds longer than 10 years are generally callable, meaning that the issuer has the right to return your principal and stop making interest payments at some point before the bond matures. In general, callable munis become callable 10 years after they are issued. Obviously, this complicates the process of building a ladder. The point of the ladder is to be predictable. Calls are inherently unpredictable. You can avoid the whole issue by buying only new bonds that mature in less than 10 years. But if you want a longer ladder, it will be difficult to avoid callable bonds, particularly if you live in a state that doesn't issue a lot of munis. Even if you could avoid them, you wouldn't necessarily want to, since noncallable bonds are much more expensive than callable bonds. The bottom line is: Know the call features of any bond you buy. If you're going to buy callable bonds, consider staggering the call dates so that if your bonds get called, at least they won't all get called at once.

Pricing: If I were going to be making a big investment in muni bonds in the near future, the first thing I would do would be to start studying the daily price reports on the Bond Market Association's Web site. These will give you a sense of how much yield you should expect from the kinds of bonds you're thinking about buying. The muni bond yield table on Bloomberg's site is another valuable resource.

Timing: Muni market pros say there are two times of the year to avoid making big investments: June into July and December into January. Loads of bonds mature, are called or make coupon payments then, which creates lots of reinvestment demand. If there aren't enough new bonds to go around, it may pay to wait.

Tax issues: If you're subject to or at risk of being subject to the alternative minimum tax, you'll want to avoid certain types of munis, mainly airport and housing bonds. Our primer on the subject has more information. Assuming you don't intend to sell your bonds before they mature, the only other tax issue you are likely to face is associated with buying regular, coupon-bearing bonds (as opposed to zero-coupon bonds) at a discount. Buying at a discount means a tax bill at maturity. If you're hell bent on avoiding a tax bill, avoid paying less than par for bonds that were issued at par.

New vs. secondary: There's no reason to limit yourself to either new bonds or secondary-market bonds, unless the secondary-market issues are selling at a discount and you want to avoid a tax bill. The comfort in buying new issues is that everyone who buys pays the same price, regardless of how many they buy, assuming they buy from a firm involved in the underwriting. The reason not to limit yourself to new issues is that otherwise comparable but higher-yielding bonds may be available in the secondary market.