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Chapter 13 Municipal Trusts and Funds—Tax-Free Alternatives
“A government is the only vessel known to leak from the top.”
Do I Need to Read This Chapter?
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• Am I in a high enough tax bracket to need tax-free alternatives? • Do I want to know more about municipal bond unit trusts? Municipal bond mutual funds?
• Am I looking to invest in units as low as $1,000?
At one time,tax-free benefits were available only to the well-to-do because any purchase of municipal bonds under $25,000 was considered an “odd-lot”amount and would cost you extra brokerage commissions (as well as being harder to sell later).Under these conditions,the municipal bond market was strictly a high-priced investor’s playground,and the cost of establishing a diversified portfolio of many municipal bonds was extraordinarily high.It was to remedy this situation that the municipal bond unit trust and the municipal bond mutual fund were developed.
What Are Municipal Funds and Trusts?
In some ways,the municipal bond unit trust and the municipal bond mutual fund are similar.Both offer a way for the small investor to buy a portion of a diversified selection of municipal bonds for as little as $1,000.Both offer investments that are free of federal income tax and,in some cases,state and local taxes (if you live in the state in which the bonds were issued).Also,both pay interest on a monthly basis,unlike the municipal bonds themselves,which pay interest only semiannually.
However,there are many differences between the unit trust and the mutual fund.Let’s explore these differences so that you can decide which of the two might be worth considering as an investment for you.
How Does the Unit Trust Work?
A municipal bond unit,also known as a unit investment trust (UIT),is established by a sponsor who purchases a substantial share in at least 10,but more often 20 or more,long-term bond issues,usually with maturities ranging from 10 to 30 years.The bonds bought by the trust are left intact and do not change once they have been purchased.Therefore,the yield of the trust remains the same throughout its life span,which has a predetermined length that ends when the bonds in the portfolio mature.When you buy a share in a unit trust, you are buying a portion of this fixed portfolio,and you can predict just how long your investment will last and how much it will pay each year.These units, also called shares,trade around $1,000 a unit.However,the exact value is based on what each issue in the portfolio is worth.
Unit trusts come in many types,which vary greatly according to length of maturity,degree of risk,tax-exempt status,and yield: 1.Examine your investment needs carefully to ensure that you choose a trust with the right combination of features for your needs. 2.Decide whether you want to buy your units directly from a sponsoring firm or indirectly through your broker. 3.In my opinion,it pays to work through your broker,who can offer you trusts assembled not only by his or her firm but by other companies as well.
Once all the units in a particular trust have been sold,no more can be issued. You can dispose of your units without incurring a penalty or sales charge by asking your broker or the sponsoring firm to redeem them.In most cases,unit trust sponsors constitute a secondary market for their own units and will guarantee to buy back your units at their current market value.Of course,this may or may not represent the same amount as you originally paid.If interest rates have risen since the trust was assembled,the rate being paid by the trust may no longer be competitive,and the market value of the units will be less than what you paid for them.On the other hand,if interest rates have fallen,you may profit when you sell your shares.
Remember the spread, as first discussed in the previous chapter on tax-free municipal bonds. The concept is the same when you are buying and selling units in a bond trust; you must take into consideration the spread between the bid price and the ask price. The bid price is what the broker pays for the bond; the ask price is the price the broker charges the investor for the same bond. The gap between the two is the broker’s profit. It averages about 2 percent of the value of the bond and is expressed in basis points (hundredths of a percentage point). Each point of the spread reduces your yield by 1⁄100 of 1 percent and costs you 0.01 percent.
Because the portfolio of a unit trust is basically fixed,managing the trust is very simple.Therefore,a very small management fee is normally charged. However,when you purchase units in the trust,you must pay a commission, which may range from 2 to 5 percent,depending on the company sponsoring the trust,the length of maturity,and other factors.
What would happen if one of the bonds in the trust should run into financial difficulties? Normally,the trustee may decide to sell that specific issue in the trust;however,unlike fund managers,trust managers are not permitted to add any new issues to a portfolio once it has been created.This tends to make trusts slower to respond when a bond’s creditworthiness is in doubt.Also bear in mind the risk of early redemption.Many new issues are callable,meaning that the bonds can be called back after a specified period of time.This may occur if interest rates fall by more than 2 percentage points,so beware of high-yield projections.Every trust prospectus must inform you of which bonds in its portfolio are subject to call and their dates of possible callability.
Do you remember our discussion on insurance for munis in the previous chapter? If you’re the type of investor who likes some insurance—and assurance—be warned that unit trusts and funds are normally not a good value. That’s because the trust or fund is formed around many individual units, not just one bond. For example, a trust having 15 bonds that saw one of its bonds lose all its money would suffer a loss of only 6.6 percent. Since the cost of insurance over a 10-year period averages about 3 percent, you can see that you pay an extremely large premium to protect yourself from a minor loss.
How Does the Municipal Fund Work?
A municipal mutual fund is similar to a money market fund:Its shares are highly liquid.Each fund sells or redeems shares at its net asset value (NAV) at any time,with some funds permitting redemption by wire transfer and even allowing investors to move from one fund to another by telephone.Whereas a bond unit trust stands pat with its investments,the managers of a bond fund are constantly trading.Thus the fund as a whole never matures,but goes on indefinitely buying and selling bonds to take advantage of changes in the marketplace.Because of this continuous activity,a higher management fee,compared with that of the trust,is charged,usually about 1⁄2 percent annually.
Participation in a bond fund usually requires an initial investment of $1,000. Any time thereafter you can buy additional shares in the fund.You have the option of receiving a check for your monthly earnings or having them automatically reinvested to purchase additional shares in the fund.Whenever you wish,you can sell your shares back to the fund.However,since the value of the bonds in the fund’s portfolio fluctuates over time,you may or may not get back your original investment when you sell your shares.
What Are the Basic Differences between the Trust and the Fund?
The differences between the municipal bond trust and the municipal bond mutual fund are summarized in Table13.1
However,you should be aware of how sensitive municipals are to interest rates.In times of stable interest rates,their after-tax yields are better than
Table 13.1 The Municipal Bond Trust and Fund Compared
Factors Unit Trust Mutual Fund
Yield Fixed Varies with market conditions Life of investment Ends when bonds mature Unending; constantly changing portfolio Average maturity 10 to 30 years 3 years or less of bonds held Purchase Fixed number of units offered Shares always available for purchase Portfolio Same bonds (15 to 20 issues) 100 or more bonds actively held to maturity managed Disposal Units sold through brokers, Shares sold back to fund as with stocks
those of most investments (for the high-tax-bracket investor);and should interest rates decline,they can add capital gains as well.It is when rates move upward that the bonds may become a problem,because capital losses can occur upon their sale.
Another problem that funds and trusts are currently experiencing involves two distinct areas:(1) the questionable quality of the bonds bought by funds and trusts looking to boost their yields and (2) the threat that bond-rating agencies might lower the grades on many munis because of the ever-growing financial strains that may cripple state and local governments.Therefore,a word of caution.Look toward safety when considering muni funds or trusts, staying only with those that invest at least 90 percent of their portfolio in the bonds rated A or higher.You can get this information from the company’s annual report by requesting a copy from your salesperson or by writing the company.
Not sure which is better for you, a unit trust or mutual fund? Follow this rule of thumb: The unit trust is a better choice if you are certain that you want to hold on to the investment for at least 5 years. If you think you may need to liquidate your holdings sooner than that—or if you anticipate shifting to other investments fairly frequently—the mutual fund is preferable. Either investment, however, is a good way for the small to medium-sized investor to get into municipal bonds with a diversified, professionally selected, tax-free portfolio of holdings.
And on the topic of taxes,Form 1040,the tax return we all file,could just as easily have been numbered 1039 or 1041.The IRS has assured the American public that the number 1040 was a random selection.Still,some taxpayers insist it’s not a mere coincidence that in Coventry,England,Lady Godiva, covered only by her long hair,rode naked through the streets protesting the high,oppressive taxes imposed by her husband,the Earl of Coventry,in the year 1040.
It’s a Wrap
• Municipal bond unit trusts and mutual funds make it possible for the small investor to buy a portion of a diversified selection of municipal bonds for as little as $1,000. • Municipal bond unit trusts vary greatly in terms of their length of maturity,degree of risk,tax-exempt status,and yield. • Municipal bond mutual funds are similar to money market funds. • Insured unit trusts and funds offer poor value,because you must pay a large premium to protect yourself from a minor loss. • Municipal bond unit trusts are generally preferable to municipal bond mutual funds for those planning to hold the investment for at least 5 years. • Given the volatility of interest rates and markets,it’s wise to stick with muni funds and trusts that invest in bonds rated A or better.
