For the longest time, Bill Schultheis was one of them. A broker. A cold-caller. A salesman who ran his finger through the Yellow Pages for people to buy municipal bonds from his firm, Smith Barney (C). Schultheis quit in 1997 and a year later wound up publishing a surprisingly subversive little book, The Coffeehouse Investor: How To Build Wealth, Ignore Wall Street and Get on with Your Life (Longstreet Press, $13).
I like the book. But what I really wanted to know from Schultheis isn't in it: How can I avoid getting hurt if I try to buy muni bonds? I figured, after 13 years selling them, Schultheis must know the ropes. And now that he's a partner in a $25 million advisory firm, Pacific Asset Management, he's often on the other side of the trade. When clients need munis, he doesn't ring up one of the Street's old-line firms, where transaction costs run 3% and more. Schultheis uses a discount broker instead. What else does he suggest?
-- Beware of calls: Many bonds can be "called"--that is, redeemed by the issuer before maturity. That's not necessarily bad, but you want to get paid for that risk, especially if you buy a bond when it's trading at a premium to its par value. You want to make sure that if, for example, the bond gets called in five years, your total yield will beat yields on similar five-year bonds.
A broker "will call you up and say, `Hey, I've got a housing bond, and it's got a great yield on it," Schultheis said. "But you've got to be careful, because conceivably that bond could be called next week at par. I've seen it time and time again." Don't buy a muni unless you know when it can be called.
-- Consider premium bonds: Everyone likes a bargain, so there's often more demand for bonds selling at a discount to par value. "Because of that psychology, you get a little bit of pickup in yield" with premium bonds, Schultheis said. For example, a AA-rated Washington State general-obligation bond issue maturing in 2019 recently traded over par, with a yield to maturity of 5.64%, 0.25 percentage points more than comparable bonds' average. It can be called in September, 2004, and, if it is, it would yield 4.81%, a "kicker" of 0.35 points or so over the typical AA, four-year bond.
-- Watch interest-rate risk: The longer-term the bond, the more liable it is to lose value before maturity if interest rates rise. True, lower rates boost a bond's value. Yet most individuals buy bonds for income or as ballast against their stocks, not to trade for capital gains. So, however tempting the yield, avoid bonds with maturities past five years or so unless they're likely to be called sooner. The average AAA-rated, five-year muni yielded 4.64% recently, while AAA, 10-year bonds yielded just 4.93%. "You get a ton of interest-rate risk with no upside," Schultheis said. Don't let a muni broker push you into it.
How does Schultheis buy munis now? He avoids muni brokers entirely, a choice he suggests for educated investors. He uses discounter Charles Schwab's (SCH) bond desk (800 626-4600), which usually operates not as a broker but as a principal. That is, it sells bonds from its own inventory and makes its money on the bid-ask spread, without commissions. Bond desks at Fidelity Investments (800 544-6666) and Vanguard Group (800 669-0514) operate similarly. Schwab bond chief John Ladensack told me that, depending on a bond's maturity and size of a trade, the firm's take is 0.5% to 1.5% of the principal. If you tell a bond desk the credit quality and maturity you want, they'll offer a selection, but no hard sell--just what this ex-salesman orders.
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