roddy sloss, individual investor

June 9, 2012Niche for an individual investor: Low Risk California Muni Bond Strategy

Roddy Sloss, Individual Investor

June 9, 2012 AAII Low Risk California Muni Bond Strategy Roddy Sloss

California Muni Bond Market

Finding Bonds

Performing the Credit Evaluation

Buying the Bond

Monitoring your Investments

GOALS and AGENDA


PRESENTER BIOGRAPHYRoddy Sloss: Individual Investor

BS, Business - University of California, Berkeley (1966)CPA California (inactive)

PricewaterhouseCoopers, Financial Auditor (1966-1979)Kaufman & Broad (NYSE), Director - Controls Evaluation & Audit (1979-1983)Cordura (NYSE), CFO / Secretary (1983-1987)Daisy Systems (NASDAQ), CFO / Secretary (1987-1990)Sigoloff & Associates, Consultant (1990-1994)Lattice Semiconductor Corporation (NASDAQ), VP Finance (1994-2005)

Retired (2005 - present)Los Altos Hills town finance committee (2008 present)


DISCLAIMERInformation presented or discussed during this meeting is neither confidential nor proprietary, was developed by the presenter and may contain inaccuracies, oversights and errors as it has not been subjected to a third party review or fact check.

The presenter is neither a professional investor, public speaker, nor a practicing accountant.

The presentation is based on market conditions at this time and for the three years ending in June 2012. This strategy is unlikely to work if market conditions substantially change.

Transactions and investments in this presentation are characterized as tax free meaning income tax free for California income tax payers. Alternative minimum tax, capital gains tax and income tax related to original issue discount may or may not be applicable in determining the income tax status of these transactions. Tax Free characterization may or may not be applicable to all recipients of this presentation and may change over time.


CALIFORNIA MUNI BOND MARKET


California Muni Bond Market Market Size


NICHE MARKET CHARACTERISTICS

Small issues

Low turnover

No exchange to resell securities

No institutional research

Legal foundation varies by state

Unrated securities common

California Muni Bond Market Why This Market Is Different


TWO MARKETS

I. INITIAL OFFERING - Better disclosure and more risk

For institutional and individual investors Invitation only

Boutique local brokers

II. SECONDARY MARKETS - Worse disclosure and less risk 2 sub SEGMENTS:

1) $100,000+ for institutional investors (Bloomberg)

2) > $100,000 online bulletin boards for individual investors

California Muni Bond Market - Market Segments


FINDING BONDS


FINDING BONDS - Getting StartedPre requisites:


Finding the Market - Free Internet Tools


Vanguards is nested5 levels downUse Advanced Search ToolFinding the Bonds Free Internet Tools


Finding Bonds Free Internet Tools Vanguard Advanced Search Screen with strategy criteria selected:


Finding Bonds - Free Internet Tools Alamo Advanced Search Screen with Strategy Criteria selected:


Finding Bonds Free Internet Tools Vanguard search results: bonds offered for sale (5/1/12)


A Case Study Stocktons threatened bankruptcy opportunity


PERFORMING THE CREDIT EVALUATION


Attributes of a good credit risk:

High ratio of collateral to bond value

Borrower able to make timely payments

Borrower reports periodically

History of ethical and responsible behavior

Payment source is observable and verifiable

Performing the credit evaluation - What is Safe?


MARKET CATEGORIES OF BONDS:

General obligation (aka GO)

Revenue (aka certificate of participation)

Community facility (aka Mello Roos)

Redevelopment (aka tax increment)

Performing the Credit Evaluation What Kind of a Bond Is it??


Performing the Credit Evaluation What Kind of a Bond Is it?$132,000,000GENERAL OBLIGATION BONDS General Obligation bonds+ Issuers credit reputation is at risk+ Most General Fund revenue sources - Hard to evaluate credit


Revenue (certificate of participation) bonds

+ /- May or may not be similar to GO e.g. building lease payable from General Fund vs. dedicated revenue from toll road

+ /- Asset financed may or may not be critical (jail vs. library)

Performing the Credit Evaluation What Kind of a Bond Is it?


Community facility (aka Mello Roos) bonds

+ Easy to evaluate

+ Often have high value to loan ratio

+ Usually not redeemed early

Be careful where property not built out



Redevelopment (tax increment) bonds + sometimes have high value to loan ratio hard to evaluate collateral is often diluted - subject to abuse



Where does your information come from?


Performing the Credit Evaluation Free Research ToolsEMMA


Performing the Credit Evaluation Initial DisclosureOfficial Statement project description deal terms risk factors taxes initial expectations early retirement


Credit Evaluation Ongoing Disclosure ResponsibilityContinuing Disclosure current performance problems new developments


Performing the Credit Evaluation Looking For ProblemsSkim Continuing Disclosure: CAFR Budgets (issuer website) Continuing Disclosure ReportMello Roos? Check for Teeter Plan

(Checklist in the Appendix)


Performing the Credit Evaluation - Drilling Down

Peruse

Peruse: Official Statement Risk factors Description of projectCAFR Budget

(Checklist in the Appendix)


The issuers website

most recent budgets and financials governing boards meeting agendas and minutes Other

Google maps Zillow .com local press telephone the issuers financial officer ask a bond trader familiar with the security

Performing the Credit Evaluation more free resources


BUYING THE BOND


Buying the Bond - Things to RememberConfirm the CUSIP # $ in account?Price flexible?Pay par or lessSet up alerts


MONITORING YOUR INVESTMENTS


Retain key data in a spreadsheet (appendix)

Summarize by year of maturity MONITORING YOUR INVESTMENTS

Total201220132014201520162017Total $232,580 $20,051 $39,915 $39,746 $79,295 $43,594 $9,979 %100.0%8.6%17.2%17.1%34.1%18.7%4% Maturity2.8 0.4 1.52.53.54.55.1


Check broker calculated unrealized gain/loss often

Use EMMA Alert service for news (see appendix)

If there is a concern, use EMMA Alert service to report new trades (see appendix)

MONITORING YOUR INVESTMENTS Free Tools


If you have to sell:

Review EMMA data (including other maturities)

Find dealers who know the bond and credit (usually found in issuers geographic area)

Contact several dealers (phone / email)

Explain why you are selling (no one wants a lemon)

If there is bad news, dont sell in a panic. MONITORING YOUR INVESTMENTS Selling


Research skills improve quickly

Dont buy if in doubt

Persistence is rewarded - mining for value

Selling can be expensive take your time Interest rates will go up stay short term

THANK YOUCONCLUSION


APPENDIX


MUNI BOND MARKET OVERVIEW ($ = market cap)

NYSE & NASDAQ $19 trillion (9,000 securities)

US Treasuries and Agencies $11 trillion

Mortgage securities $ 9 trillion Corporate Bonds $ 7 trillion

Muni Bonds - $ 3 trillion (30,000 securities / ~300,000 maturities CA 16% , Tx 10%, NY 9% )

Asset backed notes (credit cards / car loans) $3 trillion

Data from SIFMA 2012 website; NYSE & NASDAQ from Co.website and 10k; e Trade primer; Bnod Desk 7/11 monogragh, MSRB 2010 Data book. SIFMA 2012 website, NYSE and NASDAQ from co. website and 10K; E Trade primer, Bond Desk 7/11 monograph, MSRB 2010 Data Book.)

APPENDIX - California Muni Bond Market Market Size


MARKET ATTRIBUTES

45% of transactions are $25,000 or less (66% A PC; >Internet access; >The skill to read a basic set of financial statements although not necessarily the technical details in the footnotes. >Capital - from $100,000 to $200,000. You can use less, but your time spent on learning and research will not be well rewarded. I dont think there is an upper limit.>You will need a brokerage account with a secondary market dealer in California municipal securities; >And, time to search for new bonds and to monitor existing investments. After climbing the learning curve, this will take less than an hour a day and usually much less.

If you can not check the market each day, I believe it is more worthwhile to check on days when the bond market is down. That causes mutual funds to sell and as a result generally there is more product available. From 9am and 10am is a good time to look.

The first step to initiate this strategy is to begin investigating the websites that sell muni bonds.

Many of the largest banks, brokers and mutual fund dealers like Fidelity and Vanguard have them.

I use Vanguard and Alamo Capital to search for bonds. Access to both is free. I do not use Wells Fargo or Schwab because they only post investment grade bonds and that leaves out unrated bonds which can be the best ones.

It is common to find a bond listed on one website, but not others. The opposite is also common. Although I primarily use Vanguard, there are many websites I have not investigated like Fidelity, Citi and Bank of America that may be as good or better.The Vanguard website has thousands of bonds for sale each day from across the country. To find a manageable number to evaluate, use the Advanced Search tool.

The secondary market muni bond bulletin board on Vanguard is nested 5 levels down. So, finding it will take a little digging. The path is in the Speaker Notes version of these slides. ___________________________________________________________________________________________________________Path= Vanguard.com/personal investors/register for website access, then after your are registered:

Research Funds & Stocks; then Stocks, bonds & CDs; then Buy bonds and CDs, then Custom Searches, Municipals, Secondary, then Advanced Search

Enter advanced search criteria: (see next slide) then Find Bonds a screen similar to slide 15 should appear.

Note that you can save and label your advanced search criteria so you do not need to enter it again each time you log in to Vanguard. This is the Vanguard Advanced Search tool. There are more than 30 criteria to choose from. I use the 11 on the screen: ((California bonds; maturing in 2017 or earlier; with a current minimum yield of 4%; and with a price of 100 or less. I exclude: zero coupon bonds, taxable bonds, bonds subject to AMT, and variable interest rate or step coupon bonds.)) I do not buy zero coupon bonds because the $s at risk are substantially higher since they do not pay interest currently.

I limit myself to Calif bonds because I am generally familiar with the economy, the underlying legal principles, and because there are many to choose from.I do not consider maturities over 5 years because of the principal risk from interest rates rising in the next few years.

I do not buy bonds that are selling over par because of the risk they will be called in early. If that happens, usually the owner will only receive par value.

Typically the advanced search tool with these criteria produces a selection of 5 to 15 bonds most of which I have seen before and rejected based on credit quality. So, on average, I have one or two new bonds to review each week. And, on average I buy 12 new bonds a year. This strategy requires patience. It is not unusual to go weeks and even months without finding acceptable bonds. Other times, I will buy as many as four different bonds in a month.

This is crucial, this search screen will produce mostly bad credit risks. Be skeptical and careful.

This is the Alamo Capital advanced search tool. It is similar to Vanguard.

One difference between Alamo and Vanguard is that the Alamo includes the commission in the price. Vanguard does not. Right now, the maximum Vanguard commission is $2 per bond up to $250 per transaction. That is a little lower than Alamo although Alamo is sometimes flexible and Vanguard is not.

This is the Vanguard bulletin board after applying my advanced search criteria. There are only 8 bonds for sale at the moment I took this screen shot early last month. Six are Stockton bonds. In March, Stockton announced they were taking the first step in a process most believe will result in bankruptcy. Yet, 3 of the 6 Stockton bonds are offering yields in the 4% to 5% range. Considering this risk, why arent these interest rates higher? I will digress for a moment to answer the question and tell you the story about this unusual situation as an example of the credit evaluation I made to decide whether or not I want to own a Stockton Sewer System bond(1). _________________________________________________________________________________________________________(1) Cusip 861407BH6 is the Sewer bond 1998 5 1/4% par due 9/1/16.

In March, Stockton stopped making some employee payments and payments on 3 bonds out of approximately 75 bond issues(1). This action initiated a mediation between employees, bond holders and the City, that is scheduled to conclude on June 25th. If they can not resolve the issues, a bankruptcy judge will. The bonds with halted bond payments relate to assets that are either under-utilized or are not in use (office building and parking lots). The halted payments address perhaps 20% of Stocktons operating deficit. So, the fact that Stockton is still paying on many bonds provides no comfort that more bonds will not be affected. Only Stocktons General Fund is headed directly for bankruptcy. Bonds repaid from other funds are safer but not exempt from risk. Sewer bonds are in one of these other funds. Sewer bond payments are made from customer collections billed through the General Fund. The collections can only be used to pay for sewer operating costs and the bond payments. If sewer users dont pay, the County will foreclose on the related property (usually a residence) and use the foreclosure proceeds to pay the delinquent billings before the bank (or other secured lender) is paid. The sewer bond is rated BBB meaning the rating agency does not believe the bond will default, but they are uneasy about it. The bond was originally rated AAA in 1998 because it was MBIA guaranteed. MBIA is still in business but their capital is suspect so their rating dropped to the equivalent of BBB. Stockton is still paying S&P to maintain the ratings on Stockton bonds but that may not continue due to Stocktons financial situation. Then the bond will be unrated. >For now, Stocktons sewer bond financial disclosure is timely and the bond issuers are performing their obligations. >Sewer billing collections are satisfactory and delinquencies are not significant. >Further, a substantial portion of the collections come from companies with factories in Stockton and >The sewer district is obliged to increase the rates to the extent required to support operating costs and payoff the bonds. These rates have been steadily but gently increasing without an adverse impact. On the other hand, if enough users stop using sewers, there will not be enough collections to service the bond debt. And there is no earthquake insurance. In summary, the revenue stream supporting the bonds is not directly threatened by the citys insolvency. And, for now, there is a bond insurer who has the ability to continue making payments if the bankruptcy judge decides to redirect sewer collections elsewhere or users abandon the system.

This evaluation is the most complicated I have done so far. This decision was a close call for me that I continue to review. I decided to buy this bond, but I also recommended to a friend that he not buy it because of the known unknowns.This background information came from the Credit Evaluation process and that is our next subject. ___________________________________________________________________________________________________________(1) EMMA hand count w/out CF bonds - $829M Ttl 6/10estim~$30m annual deficit 2013 so far suspended $6m annual bond pays

The credit evaluation is the most important part of this strategy.

I developed my own definition of credit risk for muni bonds because tools like credit ratings, analyst reports, and financial statement metrics are not available.

I am looking for bonds that are safe. I do not want to take risk for a 4% after tax return. I want good protection that I can see and verify, financial strength, reasonably current status reporting, and an honest borrower.

To make credit easier to evaluate, I begin by profiling the bond into one of four categories each of which has unique credit characteristics.

Analysts discuss muni bonds in categories distinguished by type of collateral, unfortunately they are not presented that way when they are offered for sale. So, I do it myself. The four categories are: General obligation (usually called GO bonds) They are unsecured debt. The issuer promises to use its assets and taxing power to assure that bonds are repaid most commonly large governments like the State of California, Santa Clara County and Los Angeles issue GO bonds;

Revenue (sometimes called Certificate of Participation) is the 2nd category. This is a catch all category that is used to finance almost anything like Gos. But the revenue sources supporting the bond repayment are SOMETIMES more limited than GOs.

Community Facility aka Mello Roos bonds (named after the authors of the enabling legislation) is the 3rd category. These bonds are secured and the proceeds benefit a small number of property owners. An example is streets for a new housing sub division. And Redevelopment (aka tax increment) is the 4th category Effectively these are unsecured bonds repaid from incremental property and sales taxes from new development financed with bond proceeds. Redevelopment Agencies closed as of Feb 1, but the bonds are still outstanding. I recommend you avoid these bonds. The next four slides discuss each of the bond types in more detail.General Obligation bonds are payable from the issuers General Fund (which is where most revenues are collected and where most bills are paid.) And because of the unlimited taxing power of some issuers, it may be a safer bond than other bonds that have limited revenue sources. Most of the bonds issued by the State of California are GOs. California GOs have a high credit rating and low interest rates because of this unlimited taxing authority. Other agencies that do not have such broad taxing authority like fire and hospital districts also use GOs. Their revenues are usually limited to revenue from property tax, fees or licenses. For a GO bond, the credit evaluation requires that you dig into the financial statements and the budgets. These documents can be 100 pages of jargon filled disclosure. But, as discussed in a moment, if you know where to look and what to look for, you can navigate the disclosure without too much difficulty. Issuers do not want to default on any bonds, but because defaulting on a GO means bankruptcy, default will be a last resort after laying off staff, closing parks and libraries, and cutting back on public protection. Revenue bonds differ from GOs because either there is a specific revenue stream identified to make bond payments or there is a specific asset collateralizing the bond. Often this distinction is meaningless from a credit perspective. For example, it is not unusual for a revenue bond to be for a library, or a city hall that is built by or sold to bond holders and then leased back by the County or City. The lease is an obligation of the General Fund. Typically the lease will say the County or City will use all means possible to satisfy the lease obligations. In these cases, I evaluate a Revenue Bond as I would a GO.

I own Revenue bonds issued by California counties to finance fire engines, jails and court houses. I am comfortable with the credit primarily because the County is financially stable and can not function without these assets. Some revenue bonds are different. For example, I own bonds paid for by revenue from the BART spur that services SFO. I also own revenue bonds for a toll road in Southern California. For each of these bonds, there is an identifiable dedicated revenue stream that I can easily evaluate. But, before you buy one of these bonds, make sure the revenue stream can not be diluted with other obligations.Community Facility aka Community Development, Assessment District or Mello Roos bonds is my favorite category. This type of bond is used to finance public improvements that benefit specific property owners. These bonds are different because 1) bond payments are made directly by the property owner through the property tax bill; 2) they are collateralized by the property they are associated with (typically a house and lot); and, this is key, 3) the collateral is a first lien that has priority ahead of the mortgage except in bankruptcy, where this priority can be lost.The credit on these bonds is easy to evaluate. The bond issuer should publish a list by street address indicating if the house is completed (built out) and if taxes are paid currently. They should also publish the ratio of assessed property tax value to the bond payments outstanding (called value to lien ratio). If the property is built out, the value to lien ratio is typically between 10 and 30 to 1. In other words, no credit risk. Another plus for community facility bonds is that usually they are not called in early. Unlike corporate bonds, municipal bonds can be redeemed (typically after the first few years) by the issuer for any reason. Declining interest rates is a common reason. Individual property owners can prepay their obligation which triggers a proportionate redemption but they usually do not because they can pass on the obligation to a new owner when they sell their house. The last of the four bond categories is Redevelopment (aka tax increment). Redevelopment bonds are issued by a redevelopment district (or agency) that is a sort of subsidiary of the related City for the purpose of urban renewal. The redevelopment district is run by the same managers and elected officials as the associated city. I owned four of these bonds, but I sold them this week. The law governing the collections used to pay for these bonds is changing negatively impacting the credit quality. I recommend you avoid Redevelopment Bonds. In summary, none of these remaining three categories (GO, Revenue, or Community Facility) is fundamentally a better or worse credit risk than the other. Categorizing bonds this way is only done to simplify the task of evaluating credit.There are many places to find information for a muni bond. By selecting the best sources, an industrious small investor is often better informed than a professional investor. That is an important advantage of this strategy. By doing a little extra work, you may properly conclude a bond is safe even though the market disagrees as reflected by the price of the bond. So, knowing where to go to find information is key. This chart guides you to information sources based on your question.

The question we were just asking is: Where do you find information to determine Bond Type? The chart says go to EMMA. EMMA is an acronym for a website formally called the Electronic Municipal Market Access system. It is managed buy the Municipal Securities Rule Making Board, a public non profit established by Congress in 1994 to improve the transparency of the municipal bond market. EMMA, is the first place to go after you find an interesting bond. By entering the CUSIP # from the brokers bulletin board website, you will arrive at a screen that looks like this. There are four tabs presenting the detail information: Continuing Disclosure, Official Statement, Trading History and Rating.

For Bond type information, first go to the Continuing Disclosure section on EMMA. I look for a brief summary from which I can determine what category of bond it is. If I can not figure out the bond category from the Continuing Disclosure information which often happens, I go to the Official Statement where I can always find it.

After you determined bond type, go to Trading History. EMMA lists every trade for a bond reported to them since inception (all trades are supposed to be reported, and most are even though there is no real enforcement.) If the trading history has dips in it, that may mean there was or is a credit problem. If the bond has traded below 95% of par, I make sure I understand why before deciding to buy the bond. I will come back to the other two tabs, Official Statement and Rating, in a moment.For evaluating credit, it is useful to understand a few of the legal disclosure responsibilities of bond issuers. What are bond issuers required to tell you?

There are two categories: initial disclosure and continuing disclosure.

Initial disclosure means what the bond seller is obligated to tell you when the bonds are first offered for sale. Initial Disclosure is one of the few examples of where the muni bond market is similar to corporate bonds. An Official Statement is issued before the bonds are sold. It is similar to a Prospectus for new issues of listed securities. The Official Statement is professionally prepared by lawyers and accountants and contains everything most people think you should know before buying the bonds. Typically it is 70 to 200 pages long, searchable and well indexed. And it is available online. The type of content in the Official Statement is listed on the slide.

The Continuing Disclosure legal requirement that is important to me is what and when the issuer is required to report on developments affecting the bonds.

In California, the reporting standard is at least once a year and if something important happens. That is the standard, but compliance is uneven in terms of quality and timeliness. Penalties for non compliance are generally minor. Continuing Disclosure compliance quality and timeliness are major disadvantages of muni bonds compared to corporate bonds.

Many other legal requirements are not discussed here such as perfecting collateral, sinking funds, defeasement, subordination, insurance, payment of interest, and recordkeeping. All of these things can be important if something goes wrong. But generally they are not things I spend much time evaluating before I decide to buy.

Getting back to the credit evaluation.At this point in the credit evaluation process, I understand the bonds terms, repayment source and collateral and I am still interested. The next thing I do is skim Continuing Disclosure documents on EMMA looking for obvious problems:

For GO and Revenue Bonds,

I go to the CAFR (Comprehensive Annual Financial Report) and I read the auditors report;Then, Managements discussion looking for revenue and expense variances; and then I go to The Balance Sheet and look at Cash and Investment balances to see if they are big enough to cover the next few years bond payments;And the Equity section of the Balance Sheet looking for a negative undesignated reserve balance i.e. a deficit and/or a negative trend;6.Then I go to the financial statement footnotes looking at Debt footnote for Inter fund borrowings with excessive interest (because that may indicate questionable ethics); Then I read the Subsequent Events footnote. The Financial Statements must include important subsequent events through the date on the audit report. So, if the financial statements are the year ended June 30, 2011, and the Audit report is dated in February 2012, important events from July 2011 through February 2012 should be considered by the auditors and discussed in Subsequent Event footnotes; 8.Also I want to look at the most recent Budget (go to Town website for this item) for planned cutbacks indicating cash flow trouble; and 9.I evaluate the timeliness of filings Budgets are required before the beginning of the fiscal year and financial statements are required once a year 9 months after the end of the year. If reporting is behind schedule, it usually means the issuer is behind due to budget cutbacks and that is a yellow flag.

For Mello Roos bonds, I review:

The Value to Lien ratio and foreclosure trends in the Continuing Disclosure Annual Report;

I look to see if the Teeter Plan applies. There is a California law known as the Teeter Plan that says where the both the County and the Agency agree, The County takes the credit risk, in other words, the County must pay the principal and interest due to the bond holder regardless of whether or not collected and then the County tries to collect through foreclosure. In turn the County receives the related interest and penalties. If foreclosure proceeds are not enough to pay the back taxes, that is the Countys risk. If the County is losing money as a result of the Teeter Plan, can it elect out of the plan in the future? I dont know. It is possible.

3.Be careful, there are many uncompleted sub divisions right now with no new sales and unless the Teeter Plan has been elected, the bondholders bear the risk if foreclosure proceeds do not cover the back taxes. For example, if 95% of a sub division has been built out, and the remaining 5% are undeveloped lots, and those undeveloped lots are worth less than the back taxes, that risk is the bondholders risk. In other words, the 95% of property holders with built out lots are not responsible for paying taxes owed by other property owners who have not paid. But, if the Teeter Plan is in place, then non payment is the Countys risk. If not, it is the bondholders risk. From the document skim, you should have a clear impression of the credit picture. Next look into the details to make sure something has not been overlooked or misunderstood.

If it is a GO and for some Revenue Bonds, I know I am going to have read the full set of current financials and much of the Official Statement to confirm my understanding of the credit. With my financial skills, that will take at least 45 minutes assuming the information is available.

The GOs I own are hospital bonds. Most of their revenue is from Medicare/Medicaid. If the hospital has a reasonably high occupancy rate, say over 70%, which good hospitals should have, the government normally allows each hospitals Medicare/Medicaid billings to achieve at least a breakeven level after meeting bond payment obligations. So, here I am looking for a consistently high occupancy level.

If the bond is Mello Roos or for selected Revenue bonds like toll roads, the financials are a lesser consideration. For Mello Roos bonds, I look to see if the Teeter Plan applies and if not, I look for a 10+ Value to Lien ratio and a built out % of 98% or higher.

In the Official Statement tab on the EMMA website, I always read the Description of the Project and Risk Factors sections.

The credit rating tab on EMMA is interesting to me because if there is a current rating on the bond, there should be a current credit rating agency report in Continuing Disclosure that includes a thorough discussion of the credit risk. That is worth reading even if you ignore the rating.

Sometimes, usually with a Mello Roos bond, I am ready to conclude after reading material on the EMMA website. But, usually I want go further.

Next, I go the issuers website, looking for the governing bodys (Board of Supervisors or City Council) recent meeting agendas and minutes. They will give you an idea of priorities and concerns. If it is a Revenue bond, is management saying anything suggesting they intend to change the use of the asset in question? For example, close the library, or shut down class room buildings. (Believe it or not, individual school buildings especially in Junior Colleges are the subject of Revenue muni bonds. If I see that, I stay away. That bond was designed with default in mind.) Bonds should have funded reserves usually sufficient to cover payments for at least one year. I bought a bond maturing in 14 months from a town in the Coachella Valley even though it was in serious financial trouble because there was enough money in the bond reserve fund to cover the payment. I telephoned the Towns Treasurer to confirm that the reserve was fully funded before buying. Budgets are thorough and filled with helpful discussion. But they usually look ahead only 1 year. Bonds in this strategy may not mature for 5 years. There is no disclosure antidote for that risk.When I began buying muni bonds 3 years ago before the financial trouble in Hercules was in the press, I was interested in their bonds. I knew above market interest rates were there for a reason, but I did not know the reason. On the surface, the financial situation looked acceptable, but there were the following telltale signs of trouble: 1) The 2007 and 2008 financial statements hard large prior period adjustments. A Prior Period Adjustment is usually an error in previously published financial statements. One is unusual. Hercules has several for two years running. 2) Hercules hired a new city manager, loaned him $250,000 collateralized by his residence and took the financial risk on market value changes. That is another unusual transaction for a government agency. And 3) the City signed consulting agreements for more than $600,000 with two of the new city managers adult children.(a) These things made me uneasy. They probably bothered professional investors, too and that is the reason for the high interest rates. I did not buy the bonds. Now, of course, Hercules financial problems are well known. Another war story. I was evaluating bonds for a small water agency near the Oregon border. Half of the water was used by Arrowhead for their retail bottled water sales. The local press noted that Arrowhead stopped buying water because they purchased another well and were using the agencys well as a back up source. I called the Towns finance officer who stated there was not enough money to pay for the bonds and the Town planned to refinance. I did not buy that bond. The finance staff at borrowing agencies are candid and usually willing to talk with you. But, sometimes they do not know the answer to your questions and sometimes they take a few days to return your call.

The bond underwriter can be a good information source. They usually know the credit.

If the bond is Mello Roos, look at Google Maps to see if the property is built out and Zillow.com for property resale prices. Another point to keep in mind is that in contrast to corporate debt, government bond debt is usually structured in a way that the bondholder is well protected. Insured bonds have to meet tough cookie cutter criteria designed to protect the insurer. Even if the insurer is no longer in business, if the bond was originally insured, the bond financing structure is likely to be strong. No one profits when a bond defaults. Although muni bond defaults are rare, right now there are several Calif bonds that are in trouble (Bell, Vallejo, Stockton, Montebello and Hercules are some of them.)Sometimes, when you are done evaluating the credit, the decision is not obvious. If there is lingering doubt, dont buy.

_________________________________________________________________________________________________________________________(a) See FY 2007 Financial Statements page 57 Notes 6, and page 74 Note 15. FY 2008 Fin Stat page 67 Notes 15 and 18.

Your research is complete and you decided to buy the bond. This is the easiest part of the process. But there are few things to remember. First, for reference, look on EMMA to see what the seller paid. Some sellers tell the dealer they are willing to accept offers (take a lower price) and some tell the dealer their price is firm. Be sure to ask. My experience is that where the seller will accept an offer, an acceptable discount is usually in the order of magnitude of the commission.Make sure you are buying the bond you want. Do this by giving the bond dealer the CUSIP number only and letting him describe the bond to you.Although brokers do not require it, have the funds to pay for the bond at the broker before you buy. If the funds do not arrive by payment date, the broker will sell the bond to cover and you are almost guaranteed a loss of up to 5%.Write down the CUSIP number. It is hard to find later.If you buy from several brokers, consider consolidating your bonds at one broker to simplify recordkeeping. Moving bonds from one broker to another is usually free. The last thing to do is set up the bond so you can easily monitor it. If there is bad news or the price drops, make sure you are notified promptly. I will tell you how in the next section on monitoring your investments.

Monitoring your investment is easy. Here are a few free tools you can use.Use a spreadsheet to track your investments.

List your securities in chronological order by maturity. Then summarize the securities by year of maturity.

To the extent practical, try to even out the maturities over your holding period i.e. 5 years. Evenly layering maturities will make it easier to maintain portfolio size by avoiding a lump sum maturities.

Your account on your brokers website should give you a daily valuation that includes unrealized gains and losses usually based on last selling price of the security. I check for unrealized losses everyday.

The EMMA website has an alert service. If there is news, they will send you an email. But you have to sign-up for it.

Also, EMMA will alert you each time there is a trade of this bond. If you are a little concerned, use that alert, too.

If you have to sell:Check the EMMA website for recent trades including other maturities of the same bond if there are no recent trades for your bond. Expect to receive less than the last recent trade because you have to sell to a broker and he will want to make a profit on the trade. Vanguard offers to canvas brokers for you to get the best price. Dont rely on them. Do it yourself. Find brokers who are familiar with the bond. They are usually the ones who initially sold it and who are in the geographic area of the issuer. If you dont know who they are, call the issuers financial officer. Call several brokers to be sure you are getting the best price (like selling your car to a used car dealer).Explain why you are selling. No one wants a lemon.

If there is bad news, do not sell in a panic. Remember the Stockton bonds? I bought them on March 1, 2012, the day after Stockton announced they were beginning the bankruptcy process. I bought the bonds for 5.13% interest. Seven weeks later, they were selling for 4.3% interest. The bonds appreciated as the fear uncertainty and doubt dissipated. If you decide to sell bonds because of bad news, do not do it in a panic. Be patient. In conclusion, the hard work in this strategy is front loaded. The time investment is learning to use the due diligence tools. Evaluating credit is an art. Do not undersell your gut reaction. If you are uncomfortable because of doubts, or information you can not find, do not buy.Your persistence will be rewarded. I now earn several thousand dollars a year more than I would have if I had left these funds in a money market or CD account. If you have to sell, be prepared to make a project of it. You effort will result in a significantly better selling price.Interest rates have no where to go but up. Stay short term.

One last item to share: Recently I found a great exercise routine. I begin by standing on a comfortable surface, where I have plenty of room on each side. With a 5-lb. potato bag in each hand, I extend my arms straight out from my sides and hold them there as long as I can. I try to reach a full minute, and then relax. Everyday I do a little more. After two weeks, I moved up to 10-lb. bags; then 15 and Now I use 20-lb. potato bags holding my arms straight for more than a full minute Next week I am going to put potatos into the bags.

THANK YOU QUESTIONS?

Monitoring your investment is easy. Here are a few free tools you can use.Publicly traded securities are a $19+ trillion market as measured by Market Cap. The muni market is 1/6 of that size measured in market cap or roughly $3 trillion. California munis comprise about 16% of the muni market (~$480 billion).

But measured by the number of securities available for sale, the story is reversed. There are roughly 11,000 listed securities on the NYSE and NASDAQ. That compares to perhaps 30,000 muni bonds each of which have about 10 different maturities resulting in about 300,000 muni bond securities. California, at 16% of that total, has about 48,000 different muni bonds to choose from (5 times as many as the number of listed securities.) But, they are not all for sale all the time and generally they turnover slowly.

(Data sources SIFMA 2012 website, NYSE and NASDAQ from co. website and 10K; E Trade primer, Bond Desk 7/11 monograph, MSRB 2010 Data Book.)

Sources: MSRB 2010 FACT Book Pg 78 CA = 15% of total trades for 2010 - 6363/41630

Pg 76 remaining maturity = 7768/38469 = 20% - 5-10 years(fixed rate bonds)6947/38469 = 18% - 10-15 years9215/38469= 24% - 20-30 years 6641/38469=17% - 0-5 years

Pg 85 unique issues = 8320/17,118 = 49% 0 - $25,000(fixed rate bonds)3766/17118 = 22% $25,000-$50,000 936/17118= 5% $50-000-$75,0001635/17118=10% $75,000-$100,000

Pg 85 buyers 9668/16082 = 60%sellers6414/16082 = 40%

Pg 79 avg daily # of new issue trades 8,240/41463 = 20%

Pg 75 daily trades by end use Education 8438/38469=22% Health 3678/38469=10% Housing 1037/38469 = 3% Utility5037/38469 = 13% Transportation 3587/38469= 9% Tax Revenue3166/38469 = 8%Other Special Purpose3951/38469=10%Other9576/38469=25%Sources: MSRB 2010 FACT Book

Pg 85 buyers 9668/16082 = 60%sellers6414/16082 = 40%

Putnam monograph Barclays Capital Muni Bond Index

State GO 17%Transportation 15%Local GO 13%Special tax 11%Water & Sewer 9%Hospital 9%Leasing 8%Education 7%Power 7%Other 5%

MSRB Fact Book 2010 pg 73Taxable v non taxable (as measured by daily trades)

Sources: MSRB 2010 FACT Book

Pg 63 new issues $2568.1Pg 59 total 15027.8Derive secondary = 83%

Pg 60 Fixed rate = 51% Variable rate = 46% Zero coupon = 3%

Pg 88 Trade size>$25,000 = 7508/16835= 45%$25,000 - $50,000 = 3491/16835= 21%$50,000 - $75,000 = 865/16835=5%$75,000 - $100,000 = 1596/16835 = 9%