The Pros And Cons Of Municipal Bonds

What Are Municipal Bonds?

Municipal bonds are debt instruments issued by a county, town, city, state or other government entities.  They are used to raise money to fund public projects of the borrowing entity.

Municipal bonds are used to fund road and bridge repairs, build hospitals and schools, construct public housing, etc. Also, Municipal bonds bear either fixed or variable interest.

Let me explain:

The payment schedule will depend on the terms of the bond.  The issuing government unit receives money from investors as payment for the bonds.  In return, the issuer promises to pay the bondholder the stated interest on the bonds.  Interest is paid over an agreed period that could run from a few months to a few years.

In some cases, payment is made over 20 or 40 years and even beyond.  Once the bond reaches its maturity date, the issuer pays the bondholders the face value of the bonds.

What Are Municipal Bonds

What Are The Different Types Of Municipal Bonds?

There are three common types of municipal bonds. They are:

  • General Obligation (GO) Bonds. These are bonds secured by the “full faith and credit of the issuer”.  This means that the issuing agency will make use of means at their disposal to repay the bonds.  Investors consider them the most secure type of bond but they carry a low-interest rate.
  • Revenue Bonds. Agencies that are managed like a business often issue these bonds.  The issuer promises to use the future project’s income to pay for the bonds and their interests.
  • Assessment Bonds. They are special bonds in a sense that repayment money will come directly from taxes.  The issuing agency will levy taxes on the community that benefits from the bond-funded project.

Returns from municipal bonds will depend on each municipality or agency.  Therefore, it is important to do some research before investing in them.  Most bond specialists and mutual fund companies do regular research on municipal bonds.  Their information could help investors save time and make intelligent decisions.

What Are The Benefits Of Municipal Bonds?

Now that we have a fairly good idea of what they are, it is fair to ask some questions.  Are they any good as an investment option?  What should I know before I buy them?  We highlight three benefits.

The Interest Is Tax-Exempt

Generally, the government exempts the bond interest from federal income tax and sometimes also from state and local income taxes.  This would depend on whether you are a resident of the municipality that issued the bond or not.

Comparatively, municipal bond interests are lower than those of private bonds.  The tax-exempt benefit of the municipal bonds acts as a good equalizer.  The final yield could sometimes be at par with the corporate bonds – or even slightly higher.

For instance:

If you acquire a municipal bond and keep it until maturity, you are considered a ‘buy-and-hold’ investor.  The Federal Tax Law may give special tax treatments for the interest on this bond.  Normally, the difference between the discounted issue price and its face value is taxed as capital gains.  In this case, it would be considered tax-exempt.

Generally, the interest on municipal bonds enjoys tax-exempt status.  However, there could still be federal and state taxes when you buy, sell, trade or own the bonds.  Please check on articles about tax risks to get more information about it.

Municipal Bonds Carry A Low Default Risk

Municipal bankruptcies and agency shut down are possibilities in the market.  However, they have been insignificant compared to the corporate bond market.  Historically, municipal bonds are taking longer and longer before they default.  Another good news is that recovery is also increasing.  This means that a higher percentage of issuers that defaulted were eventually able to settle their debts. Municipal bonds that are rated by the three major rating agencies for municipal bonds have experienced very low default rates.  Most of the highly rated ones are general obligation bonds.

Take a look:

Moody’s Investor Service’s Annual Default Study for 2015 attests to the viability of municipal bonds.  The study showed that despite four US municipal defaults in 2015, the overall credit quality is still stable.[i]  A similar study by the same group revealed that from the years 1970-2011, only 71 municipal defaults occurred.  Only 5 among the 71 were general obligation bonds.

A municipal default is also not a very easy thing to do.

The federal bankruptcy law requires the state to first authorize a municipality to file for insolvency protection.  Although states have different laws about this, the state government will closely scrutinize each application before they approve them.

Municipal Bonds Are Useful Diversifiers For Your Portfolio

Diversification protects you in case of market fluctuation.  The key is to have instruments in your portfolio that do not move the same way the market does. For example, if the stock market goes down, you want the other investment vehicles to go the other way.  This will help you gain whatever you may lose from the other market’s decline (Similar to gold investment, for example)

Historically, high-yield municipal bonds have been unaffected by the movement of other asset classes.  They are great diversifiers because they behave differently than equities, deposits and treasury bonds.

What Are The Pitfalls Of Municipal Bonds?

Municipal bonds are not totally risk-free.  Here are some of the risks:

Your Tax Bracket May Not Protect You From Bond-Related Taxes

Municipal bonds have high yields and a tax-exempt status but not for all investors.  There may be tax consequences for those in certain tax brackets or for certain types of account.

A portion of the bond income may still be subject to the federal alternative minimum tax.  Also, if you sell the bond, you may be required to pay the capital gains tax or other types of taxes.  The capital gains tax rate will depend on how long you held on the bond.  It may be the current capital gains tax rate or your ordinary income tax rate.

But remember this:

When you have purchased your bond on the secondary market, the price could be different from its maturity value.  If your purchase price is lower than the bond’s stated redemption value, you have received a market discount. In such a case, you may have to pay taxes on the gains you’re realized from the market discount.  For this, the government will use the ordinary income tax rate.

Always remember that tax laws may change anytime.  The law may modify or even remove the tax advantage after some time.  It is always advisable to check with your tax advisor before deciding to purchase not just bonds but any security.

Interest Rates In The Market Can Devalue The Bonds

The fluctuations in the interest rates in the market affect the prices of municipal bonds.  Although it is a fixed rate instrument whose coupon rate and maturity do not change, it somehow suffers.  If interest rates increase, the market prices of outstanding bonds typically go down.

This is more common for bonds with longer maturities than bonds with a shorter due date.

The Issuer Can Redeem The Bonds At Any Time

Many municipal bonds carry a provision that allows the issuer to repay the bonds before their maturity dates. Bondholders cannot always avoid this call risk. When prevailing interest rates drop, the issuer can call or redeem the bonds.  Afterwards, they can re-issue the bonds at a lower interest rate.

In such circumstances, it becomes unattractive for an investor to reinvest in the same bonds.  Some municipal bonds are callable any time regardless of their stated call features.  They include some housing bonds and certificates of participation (COP).

Issuers also call bonds to change the terms through a new offering.  Before buying a bond, you should look out for extraordinary redemption provisions.  Some bonds give the issuer the right to recall due to a one-time event.  It could be a natural calamity, suspension of a revenue source, unused bond proceeds or a canceled project.

Municipal Bonds Carry Liquidity Risks

Traders and investors do not actively trade municipal bonds in the market.  Because of this, the market may not be remarkably liquid. There are just so many issuers and types of bonds available at any given time.  If one were to look for a specific type of municipal bond in the secondary market, the chance of success is limited.

The Municipal Securities Rulemaking Board (MSRB) offered a more practical view.  An investor should first identify the basic characteristics of a municipal bond he is interested in.  He can list the agency, its creditworthiness, the maturity range, interest rate, yield, market sector and other criteria.  If he cannot find the perfect fit, it would be easier to settle for an alternative that closely meets his standard.

Also, if you want to sell your bonds in the market before maturity, it will be challenging if not extremely difficult.  The municipal bond market is very thinly traded and severely fragmented.  It is practically a matter of luck to find a buyer willing to purchase your bonds at your terms.

The Issuer’s Expected Revenues May Not Materialize

We know that revenue bonds are dependent on the project’s earning capacity at a later time.  The issuer will pay off the bond’s principal and interest using the anticipated income from the project.  This is where general obligation bonds have an advantage because the issuer can use other funds to retire the bonds. In revenue bonds, consumer spending directly affects the income stream that provides funding for the bonds.  Consumer behavior is influenced by changes in consumer tastes and economic conditions.

Here’s the secret:

The key consideration when it comes to revenue bonds is the project’s vital necessity to the community.  How essential is the project to the public? For example, an undertaking to provide a better water system for the town will be more viable economically.  Its capacity to continuously provide revenue later is definitely very high.

An investor should consider the following items when evaluating revenue bonds:

  • The total economic health of the region or customer base
  • The capability of the customers to sustain the project’s revenues
  • The exact income stream that will service the debt (Will it be from a single source? Is there a larger entity standing behind the bonds?)
  • The issuer’s track record in managing the agency through multiple economic cycles (Is there a consistent record of growth? Do they have programs that expand the customer base?)
  • The legal conditions that specifically protects the bondholders such as rate agreements and contingency funds
  • The issuer’s competence in financial and credit management (Do they have a good and improving credit rating? Do they manage their debts reasonably?  Do they show good judgment in allocating their funds to debt payments and normal public services?)

Inflation Would Always Affect Your Purchasing Power

There is also an inflation risk with bonds.  Over time, inflation will diminish the actual value of the interests you will earn and the bond principal you will collect.  Since bonds take a long time to mature, inflation will eventually catch up.

The Issuer May Repudiate The Bonds

.  Even if you are dealing with a government entity, there is really no assurance that the issuer will prioritize repayment.  The issuing agency may partially or totally repudiate the indebtedness.  This can happen if there are reasonable grounds to serve other more important civic purposes.

Finally, Here Is The Crux Of The Matter On Municipal Bonds

Investors must be aware that municipal bonds are not risk-free.  The dangers may be limited compared with other instruments but they are still real risks.  Follow the essential rule in investing before you part with your money.  Do your homework to make sure that municipal bonds are right for you.

Investors must always consider the different risks we’ve talked about.

  • The tax risk is a situation that may expose you to other forms of taxes.
  • The inflation risk will lower the real value of your earnings and principal later.
  • The repudiation risk where the issuer can hold or defer repayment of the bonds.
  • The interest risk can cause opportunity losses when interests go up.
  • The call risk will disturb your cash projections when the issuer pays the bonds earlier than the maturity date.
  • The liquidity risk might limit your chances of getting a good deal when you trade the bonds in the market.
  • The revenue sources risk may lead to default because the expected income is not enough to service the bonds.

However, if you are willing to do adequate research and study, municipal bonds remain to be a great investment option.  They are generally tax-exempt.  They have a minimal probability of default. Also, they are good for diversifying your portfolio.  If you do your homework, you ought to be able to pick the right municipal bond for you.  And chances are, they will give you all the benefits you are looking for.

The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.