If you’re contemplating using individual municipal bonds as a reliable and accessible funding source, you may want to reconsider. While holding top-rated municipal bonds carries low risk, the process of selling them can be both costly and complex.
In contrast to stocks, which enjoy $0 trading fees and high liquidity, the municipal bond market is significantly less fluid. Consequently, attempting to offload municipal bonds might force you to accept much lower prices than their actual market value.
The crucial lesson here is that if your investment strategy includes individual municipal bonds for tax-efficient income, it’s best to plan on holding them until they mature. Relying on these bonds as a quick source of cash in emergencies or for major purchases like a house is not advisable.
It’s important to distinguish between owning individual municipal bonds and investing in a bond fund. The latter usually offers greater liquidity but lacks a specific maturity date.
Using Municipal Bond Sales for a House Down Payment
The closer you are to purchasing a house, the more of your down payment should be in cash or low-risk investments like Treasury bills. When you’re ready to buy, typically a minimum 20% down payment is required to stay competitive in the housing market.
Given the steep cost of homes today, a 20% down payment often represents a significant sum. It would be risky to invest this down payment in volatile markets like stocks. The more you need to stretch to afford the down payment, the more conservative you should be with the investment of these funds.
Some might consider investing their down payment in individual municipal bonds instead of in cash or Treasuries, attracted by the tax benefits. Municipal bond interest is exempt from federal and often state taxes if the bonds are issued within your state. Thus, the higher your tax bracket, the more appealing municipal bonds become.
However, despite potentially yielding higher net returns, individual municipal bonds are not recommended for parking your down payment. They might prove difficult to sell, or if you do manage to sell, you may need to accept a significant markdown.
Bond Table Sorted by Duration
Before diving into my experience with selling municipal bonds, let’s understand why some might prefer munis over Treasuries or other bonds. Observe the table below.
You can choose a two-year Treasury bond yielding 4.91% or a two-year Aaa-rated municipal bond yielding 3.98%. If you’re in the 37% tax bracket, the Treasury bond’s effective yield after federal taxes would be 3.09%, as you pay federal income tax on bond income but not state tax.
Since 3.09% is less than 3.98%, individuals in the 37% tax bracket may favor the municipal bond, assuming they hold it to maturity. In this scenario, the breakpoint is a 19% tax bracket, which currently doesn’t exist.
With tax brackets jumping from 12% to 22%, anyone in a 22% bracket or higher would benefit more from a municipal bond, provided they hold it until maturity.
Municipal Bond table
Holding individual bonds to maturity protects you from potential capital losses if interest rates rise during your holding period.
Since early 2022, all bond types have suffered due to soaring inflation and interest rates. Therefore, selling bonds now is far from ideal.
First Unanticipated Problem with Holding Municipal Bonds
When I placed a contingent offer on a house, I expected around $400,000 of the proceeds to come from municipal bonds I’d held for over six years. Despite anticipating some losses on these bonds, they were necessary to offset gains from stock sales.
Unexpectedly, I found I couldn’t sell about $200,000 worth of municipal bonds in my Citibank account! After two weeks of attempts by my wealth manager, we couldn’t find any buyers, even at reduced prices.
This posed a significant problem: how to cover the $200,000 shortfall?
Reason #1 against relying on individual municipal bonds for liquidity: they might be unsellable.
Inability to sell your bonds could lead to contract issues in your house purchase, possibly even resulting in the loss of your earnest money deposit if you release financing contingencies before realizing the illiquidity of your bonds. Caution is advised.
Second Unanticipated Problem with Holding Municipal Bonds
I then turned to my Fidelity account, which also held municipal bonds. Anticipating similar difficulties, I contacted a representative for assistance.
The bond-selling process at Fidelity involved several steps, starting with selecting the bond and initiating a Sell request. Then, I had to scroll down for a Bid Request.
Selling municipal bonds is cumbersome – Bid request example
Bid Requests aren’t immediate; the system takes about an hour to assess demand for the bond amount you wish to sell. You’re notified via text or email.
This process proved inconvenient, as I was at the beach with my daughter at the time. Moreover, the Fidelity app didn’t support municipal bond sales, so I had to phone Fidelity upon receiving the bid request alert.
Bids expire quickly, often within five minutes of receipt, necessitating
a fast response. If missed, the entire process must be repeated.
Example Of Muni Bond Bid Request Results
Here’s a snapshot of my expired Bid Requests, missed because I wasn’t vigilant an hour later.
Submit bid request for bonds
The second unexpected issue in selling individual municipal bonds was the cumbersome process. Selling a bond took significantly longer compared to instantly trading stocks through a mobile app.
Reason #2 against counting on municipal bonds for liquidity: the process isn’t instant.
Final Unanticipated Surprise in Selling Municipal Bonds
Selling my municipal bonds before maturity was never my plan, especially during a bond bear market. But when my dream home reappeared at a lower price, I decided to seize the opportunity. The home’s discount would more than offset my bond-selling losses.
Upon reviewing my bid requests, I was shocked by the large bid/ask spreads – ranging from 1% to 4%, averaging around 2.85%.
For instance, selling $10,000 worth of bonds meant either paying or accepting $100 – $400 less. Initially, I reluctantly accepted some offers, grateful to find a selling avenue. However, upon reflection, the 1% – 4% selling cost seemed exorbitant. I preferred holding the bonds to maturity rather than incurring such high fees.
Below is an example of a bid price of $59.801 for a zero-coupon municipal bond, well below its market price of $61.643, resulting in a 2.94% spread/fee.
huge bid ask spread for selling a municipal bond
In a subsequent municipal bond sale, I encountered a much tighter bid/ask spread, suggesting that the spread can vary based on the bond type and interest rate environment. If faced with a large spread, it might be wise to delay selling and try again later.
smaller bid ask spread when selling municipal bonds
Reason #3 against relying on individual municipal bonds for liquidity: potential steep discounts on sales.
Brokerage Differences in Selling Municipal Bonds
Citibank proved less effective than Fidelity in selling municipal bonds. Citibank’s inferior trading platform and limited access to municipal bond liquidity highlighted the disparity.
Since I couldn’t sell $200,000 worth of bonds at Citibank, transferring my portfolio to Fidelity was an option. This transfer would take about 7-10 days, which wasn’t problematic given my long escrow period. However, for those needing quicker access to funds, this isn’t viable. Post-sale, funds take two additional days (T+2) to settle.
In hindsight, Citibank’s inability to sell my bonds was fortuitous, saving me from significant selling costs. I also decided against selling my Fidelity municipal bonds due to the fees. Instead, I aim to grow my bond portfolio, capitalizing on higher interest rates for increased passive income.
Sourcing Alternative Capital
To cover the capital shortfall, I considered several options:
- A bridge loan from my parents at a 5.5% interest rate.
- Tapping into my rollover IRA, using the 60-day rollover rule to return funds within two months.
- Seeking additional income through jobs or consulting, coupled with expense reduction.
- Requesting my wife to access her taxable retirement portfolio.
We decided against a mortgage due to high interest rates, application time and costs. Instead, converting stocks into a home seemed more appealing, especially after the market rebound.
Conclusion: Rethink Municipal Bonds for Liquidity
In summary, don’t view municipal bonds as a cash equivalent due to high selling fees and selling difficulties. The longer a bond’s duration, the more it loses value if interest rates rise.
For those saving for a house down payment, consider 3-month or 6-month Treasury bills. Their impact from rising rates during your holding period is minimal, and the Treasury bond market offers high liquidity, unlike municipal bonds.
My time in finance taught me why bond traders often rank among the wealthiest employees. The substantial fixed-income bid-ask spreads enable traders to profit handsomely if they can meet market demands effectively.
Invest in individual municipal bonds with the intent to hold them to maturity. Only consider selling them early if interest rates plummet and their values soar.
