How The Smart Money Builds The Ideal Municipal Bond Portfolio

by: Glen Rosenberg

(For a video version of this demonstration, click: Building The Ideal Municipal Bond Portfolio.)

The following summarizes how to build a municipal bond portfolio to simultaneously seek to achieve maximum income as well as principal protection:

  1. Build the core of the portfolio around bonds backed by taxes and essential service revenue.

This is not to say that other types of bonds should be excluded. Municipal bonds in general historically have a track record of safety second only to U.S. Treasuries. However, bonds backed by taxes and essential service revenue have been shown to be of the highest quality within the asset class.

The core of the portfolio should consist mainly of investment grade bonds (BBB through AAA). However, when selecting bonds to include in the portfolio, give greater consideration to the type of bond rather than the rating on the bond.

Non-rated bonds could qualify to be included as part of the core of the portfolio, so long as they are tax backed or essential service bonds, and so long as your investment firm can verify the quality of the issuer.

  1. Play both financial offense and defense.

Include bonds that are defensive to protect against rising interest rates. Short term bonds (10 years and less) are considered defensive, as generally speaking, they will hold their value significantly better than long term bonds in a rising interest rate environment. Short term bonds may also position you to increase income in the future through swapping into longer term bonds that may be discounted by rising interest rates. Additionally, premium bonds, though often misunderstood, may be utilized as part of a defensive strategy as well.

Include bonds that are offensive (higher yielding, longer term bonds) in order to generate higher income today in case interest rates remain low for an extended period of time.

The proportion of defensive bonds to offensive bonds will depend on the interest rate environment at the point you enter the market. If rates are low, than you will likely want more defensive bonds. If rates are higher, than you will likely be hunting for more offensive bonds.

  1. Be disciplined and limit the portfolio to regular size positions.

A "regular" sized position would be a function of the size of the portfolio and the investor's total net worth. Here is a simple example:

Melvin has a $1.75 million net worth made up of a $1,000,000 portfolio of muni bonds, a $400,000 home he owns outright, and a $250,000 stock portfolio. For Melvin, a "regular" sized position might be $50,000 / bond.

Each "regular" sized position would represent 5% of Melvin's bond portfolio and only 2.86% of his overall net worth.

A simple way to think about position size is to think about a dart board. Imagine the bulls-eye represents a bond that is a perfect fit - a great combination of coupon, maturity, and credit quality and a bond that is cheap relative to the market.

When you come across a bond that is a bulls-eye, you take a "regular" sized position ($50,000 in Melvin's case).

When you come across a bond that is close, but not exactly a bulls-eye, perhaps you take a position slightly smaller than "regular" size (i.e. $35,000 for Melvin).

When you come across a bond that is definitely not a bulls-eye, but is still attractive enough to at least have a position, perhaps you take a half of a "regular" sized position or smaller (i.e. $20,000 - 25,000 for Melvin).

Populating a portfolio according the "dart board" method results in a portfolio that is weighted more towards the type of bonds that represent a bulls-eye for you.

By following these 3 guiding principles, you build a portfolio that is built around the highest quality type of bonds, you are protected if interest rates go up, or if they remain low for an extended period of time, and you are very diversified in the event that you have trouble with any of your bonds.

In addition to following the municipal investing principles mentioned above, you can further maximize your income by utilizing non-rated bonds, premium bonds, special tax assessment bonds, "safety net provider" hospital bonds and other niches within the municipal market where bonds are overlooked and undervalued. Working with a firm that specializes in muni bonds can help you in taking advantage of these opportunities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Investing in municipal bonds involves risk, including market fluctuations and potential loss of principal. This has been produced solely for informational purposes and is not to be construed as a recommendation of any particular investment or investment strategy. It is also not a solicitation or an offer to buy or sell any securities or related financial instruments. You should consider consulting a broker or investment professional before investing or implementing any investment strategy. The preceding presentation is based on information obtained from sources believed to be reliable but no independent verification has been made, nor is its accuracy or completeness guaranteed.