If you’re thinking about using individual municipal bonds as a stable and easy source of funds, you might want to think again. While holding high-quality municipal bonds is generally low risk, selling them can be both expensive and complicated.
Unlike stocks, which can be traded without fees and with high liquidity, the municipal bond market is much less active. This means that trying to sell your municipal bonds could result in accepting significantly lower prices than their true market value.
The key takeaway is that if you’re incorporating individual municipal bonds into your investment strategy for tax-efficient income, it’s wisest to hold onto them until they reach maturity. Depending on these bonds for quick cash in emergencies or for significant expenses like buying a house is not recommended.
It’s also crucial to differentiate between owning individual municipal bonds and investing in a bond fund. The latter typically offers more liquidity but doesn’t have a set maturity date.
Considering Using Municipal Bond Sales for a Home Down Payment
As you get closer to buying a home, more of your down payment should be in cash or in low-risk investments like Treasury bills. When it’s time to purchase, you’ll usually need at least a 20% down payment to be competitive in the housing market.
Given today’s high home prices, a 20% down payment can represent a large amount of money. It’s risky to have this down payment tied up in volatile markets like the stock market. The more you’re stretching to make the down payment, the more conservatively you should invest these funds.
Some people might think about putting their down payment in individual municipal bonds instead of in cash or Treasuries, attracted by the tax benefits. Interest from municipal bonds is exempt from federal taxes and often from state taxes if the bonds are issued in your state. Thus, the higher your tax bracket, the more attractive municipal bonds become.
However, despite the possibility of higher after-tax returns, individual municipal bonds are not recommended for holding your down payment. They might be hard to sell, or you might have to sell them at a significant loss.
Before sharing my experience with selling municipal bonds, let’s look at why some might prefer them over Treasuries or other bonds. Consider the table below.
You might be choosing between 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 effective yield of the Treasury bond, after federal taxes, would be 3.09%, since you have to pay federal income tax on the income from the bond but not state tax.
Since 3.09% is less than 3.98%, those in the 37% tax bracket might lean towards the municipal bond, assuming they hold it until maturity. Here, the break-even tax bracket is 19%, which doesn’t currently exist.
With tax brackets jumping from 12% to 22%, anyone in a 22% bracket or higher would see more benefit from a municipal bond, assuming they hold it to maturity.
Holding individual bonds to maturity shields you from potential capital losses if interest rates rise while you’re holding the bond.
Since the beginning of 2022, all types of bonds have been hit hard by rising inflation and interest rates. Therefore, now is not the ideal time to sell bonds.
The First Unexpected Issue with Holding Municipal Bonds
When I made a contingent offer on a house, I expected to fund about $400,000 of the purchase with municipal bonds I had held for over six years. Although I expected some losses from these bonds, they were needed to balance out gains from selling stocks.
To my surprise, about $200,000 worth of municipal bonds in my Citibank account couldn’t be sold! Despite attempts by my wealth manager over two weeks, we couldn’t find any buyers, even at discounted prices.
This created a big issue: how would I cover the $200,000 gap?
One reason not to depend on individual municipal bonds for liquidity: they might not be sellable.
If you can’t sell your bonds, it could complicate your house purchase contract and potentially lead to losing your earnest money deposit if you release financing contingencies before discovering the illiquidity of your bonds. Be cautious.
The Second Unexpected Issue with Holding Municipal Bonds
I then looked to sell municipal bonds in my Fidelity account. Expecting similar challenges, I reached out to a representative for help.
The process to sell bonds at Fidelity involved several steps, beginning with choosing the bond and placing a Sell order. Then, I had to look for a Bid Request.
Selling municipal bonds is cumbersome – here’s an example of a Bid request. Bid Requests aren’t immediate; it takes about an hour for the system to gauge the demand for the bond amount you’re trying to sell. You’re notified by text or email.
This was 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 call Fidelity upon receiving the bid request alert.
Bids expire quickly, often within five minutes of being received, requiring a prompt response. If missed, you have to start over.
Here’s an example of expired Bid Requests, which I missed because I wasn’t alert an hour later.
The second unexpected challenge in selling individual municipal bonds was the cumbersome process. Selling a bond took much longer than instantly trading stocks through a mobile app.
Another reason not to rely on municipal bonds for liquidity: the process isn’t instant.
The Final Unexpected Surprise in Selling Municipal Bonds
Selling my municipal bonds before maturity was never my intention, especially during a bear market for bonds. But when the house I had been dreaming of became available again at a reduced price, I decided to go for it. The discount on the home would more than make up for the losses from selling the bonds.
When I looked at my bid requests, I was shocked by the large bid/ask spreads – they ranged from 1% to 4%, averaging about 2.85%.
For example, selling $10,000 worth of bonds meant either losing or having to accept $100 – $400 less than expected. Initially, I reluctantly accepted some offers, thankful to find any buyers at all. But after some thought, the 1% – 4% selling cost seemed too high. I decided it was better to hold onto the bonds until maturity rather than pay such steep fees.
Below is an example of a bid price of $59.801 for a zero-coupon municipal bond, significantly lower than its market price of $61.643, leading to a 2.94% spread/fee.
In another sale of municipal bonds, I found a much tighter bid/ask spread, indicating that the spread can vary depending on the bond type and the current interest rate environment. If you’re faced with a large spread, it might be better to wait and try selling again later.
Another reason to be cautious about counting on individual municipal bonds for liquidity: you might have to sell at a steep discount.
Differences in Brokerages When Selling Municipal Bonds
Citibank turned out to be less effective than Fidelity in selling municipal bonds. The poor trading platform at Citibank and limited access to liquidity in municipal bonds highlighted this difference.
Since I couldn’t sell $200,000 worth of bonds through Citibank, transferring my portfolio to Fidelity was an option. This transfer would take about 7-10 days, which wasn’t an issue due to my long escrow period. However, for those needing faster access to funds, this wouldn’t work. After the sale, it takes an additional two days (T+2) for the funds to settle.
Looking back, Citibank’s failure to sell my bonds turned out to be a blessing in disguise, saving me from significant selling costs. I also decided not to sell my municipal bonds through Fidelity because of the fees. Instead, I plan to grow my bond portfolio, taking advantage of higher interest rates to increase my passive income.
Finding Alternative Capital
To make up for the shortfall in capital, I explored several options:
A bridge loan from my parents at a 5.5% interest rate. Withdrawing from my rollover IRA, using the 60-day rollover rule to return the funds within two months. Looking for additional income through jobs or consulting, combined with cutting expenses. Asking my wife to tap into her taxable retirement portfolio. We decided against getting a mortgage because of the high interest rates, the time and cost involved in applying, and the appeal of converting stocks into a home, especially after the market rebounded.
In Conclusion: Rethink Using Municipal Bonds for Quick
Cash In short, don’t treat municipal bonds as if they’re the same as cash because of the high fees involved in selling and the difficulty of finding buyers. The longer a bond’s duration, the more its value drops if interest rates go up.
If you’re saving for a down payment on a house, think about using 3-month or 6-month Treasury bills instead. Their value won’t be affected much by rising rates during the time you hold them, and the Treasury bond market is much more liquid than the municipal bond market.
My experience in finance has shown me why bond traders are often among the wealthiest in the industry. The wide bid-ask spreads in fixed income allow traders to make a lot of money if they can effectively meet the demands of the market.
Invest in individual municipal bonds with the intention of keeping them until they mature. Consider selling them early only if interest rates drop significantly and the bond values increase accordingly.
