Impostors!

This weekend I went on a 'walk' which is recession code for shopping these days and I came across this beautiful sweater that was 75% off. I immediately grabbed it and tried it on and was going to buy it when as I was carrying it to the register, I noticed a hole in it. Of course I put said sweater back and kept 'walking'. This got me thinking though, what if I had bought the sweater and then realized that it had a hole in it when I got home? I would have been screwed. This can actually happen with bonds as well. Below is a list of flawed bonds with descriptions of why these securities belong on Canal Street as opposed to in your portfolio.

COPs : Certificates of Participation (COPs) are bonds that can be brought into the market without a vote. When you're dealing with a regular municipal bond, for the issuer to bring the bonds onto the market, individuals vote on the issue and if enough people vote 'no' the issue will not be brought onto the market. COPs do not have to be voted on meaning that the issuer can bring out a bond issue, even if it's not in the best financial place to do so. What makes these bonds such poor quality is that instead of being supported by a specific revenue, a committee meets annually to appropriate funds for the payout of these bonds. This committee is also legally able to decide not to appropriate funds should the issuer have financial trouble. In economic hard times like we're in, it's likely many COPs will decide not to pay out and the holders of these bonds will be left out in the cold with nothing to keep them warm except a sweater with holes in it.

Notes of Anticipation : Notes of Anticipation are often passed off as regular bonds when in fact they are far from the quality of true bonds. Notes of Anticipation means that the revenue to pay them is not factored into the issuer's budget, the bonds are payable from anticipated (as in what they hope or plan to get) revenue. Whether we are in a recession or not, I do not think it's wise to buy a bond where you have to hope the issuer makes certain revenues to pay for your bond. You may have heard about Orange County CA defaulting a few years ago. Orange County CA bonds were fine, it was their notes that defaulted. While you may not need a sweater in Orange Co. CA, you get the idea...

Tobacco Bonds : Many states have bonds that are Tobacco Settlement bonds. These bonds are not actual bonds of the town or county or state that these bonds are in, they are backed by the cigarette companies. Basically the cigarette companies lost a bunch of law-suits for selling something that gave a bunch of people cancer, they needed money to pay for these suits, so they issued bonds. The fact of the matter is that with more and more people quitting smoking along with the tobacco companies continuing to lose law-suits, how long will these companies stay in business and have the money to pay off their debt? If you really think that these tobacco companies are worth their salt, er, tobacco, you should buy their coporate bonds. At least that way you'll know exactly what's backing your money.

Natural Gas Bonds : Municipal bonds that are natural gas bonds are not essential service revenue bonds meaning they are not payable from everyone's gas bills. In fact, they're not supported by any gas at all. These bonds are obligations of a financial institution. If you happen to buy a natural gas bond that's backed by Goldman, then you're sitting pretty, for those people who happened to buy natural gas bonds that were backed by Lehman, never mind a sweater with holes, they're pretty much working with a few shreds of yarn. These bonds are now worth about 3 cents on the dollar which really stinks for anyone who bought them around 90. Similar to the tobacco bonds, if you're going to buy a natural gas bond, find out which financial institution actually supports it and buy their corporate bonds. This way you'll be fully aware of how much risk you're taking.

AMT Bonds : The Alternative Minimum Tax was put in place in 1986 as a tax on people with a lot of deductions. Since the rate has stayed the same since 1986, with inflation along with bracket creep, more and more people fall into the AMT every year. If you are in the AMT and buy a bond that is subject to it, your investment will essentially be taxable. Even if you are not in the AMT, I would be careful when buying these bonds because you could fall into it with in the next few years.

While these bonds are always on sale meaning that you can get them for much cheaper than regualr bonds, each of them comes with a price. Usually that price is quality. So if you're looking to buy a municipal bond and the price seems too good to be true, take a second look, your investment probably has a hole in it.