How Munis Work

Hey all, sorry it’s been so long. This semester is going to be a pain in the rear, but I’ll try and update more often from now on.

This is the first post in a series of four entitled, “Munis - So Hot Right Now.” I wrote the entire article recently, and split it up into segments for easier digestion. The remaining parts will be released every day for the next 3 days. Enjoy.

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I. How Munis Work
Before we get into why munis are your best bet in hard economic times like these, let us first analyze how they function in a market.
Munis have three major parameters that concern you:
-    the Price (the current price of the bond)
-    the Coupon (the annual return rate)
-    the YTM (Years to Maturity, also known as “maturity date”)
The fourth parameter is typically not cited often, as it is an assumed value. With municipal bonds, this value - called face value - is almost always 100.  This will become important later as we discuss the calculation of yield (payout).
Investing in a bond will result in a payout that is known as an adjusted current yield (ACY). How does one typically calculate ACY? Ignoring the units of measurement for each value, this is the formula you use:
ACY = [(Coupon ÷ Price) x Face Value] + [(Face Value - Price) ÷ YTM]
This formula is your new best friend; your weapon in the battle against a chaotic economy. Let’s use it on the archetypal municipal bond, which has the following values:
Price = 100
Coupon = 5%
YTM = 10 years
These values are standard. The coupon is almost always 4-5%, the maturity date is generally about 10 years out, and the price is normally the same as the face value (not anymore - hence why I made this blog in the first place). So, doing our calculation, we get:
ACY= [(0.05/100) x 100] + [(100 - 100)/10] = 0.05
That return value of 0.05 can be interpreted as a 5% return on your initial investment per year over the 10-year period it takes for the bond to mature, or pay out. As we can see, the effective yield and the coupon are exactly the same in this case. That seems like a pretty safe investment, but not all that exciting. Truth be told, munis weren’t that exciting for a long time - not until the bond market (and all markets for that matter - equities especially) got mutilated in 2008.

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That’s all for tonight. Come back tomorrow for part II!