Are municipal bonds losing their reputation for being one of the safer investment strategies? Learn ways to evaluate the potential risks and rewards of municipal bonds.
Muni bonds have historically allowed investors to preserve capital and minimize taxes, but reports of municipal defaults suggest that munis may now count among riskier investment strategies. How can investors evaluate the risks and benefits of individual municipal bonds?
Today the commonwealth of Pennsylvania saw a cut to its credit rating for general obligation bonds. Moody’s Investor Services, one of three major credit-ratings agencies, dropped the rating to Aa2 – the agency’s third-highest rating - from Aa1 on concerns over high debt levels and unfunded pension liabilities, combined with low population growth and a challenging economic recovery that contribute to a “weakened financial” position. Earlier this month, Stockton, CA - a municipality hit hard by the housing crisis - made news by becoming the largest U.S. municipality to enter bankruptcy.
At the same time, the share of municipal bonds issued with insurance has fallen from more than 57 percent of the $37 trillion muni market in 2005, to 5.5 percent of muni bonds issues in 2011, according to a recent report from Thomson Reuters. Last week, Warren Buffett told Bloomberg News, to expect more municipal defaults now that the “stigma” has been removed. In light of recent headlines, should investors continue to consider munis among their investment strategies for capital preservation. (Munis are a traditional favorite of high net worth investors.)
“Any prudent investment begins with you – the investor – considering, among other things, why you are investing, when invested funds might reasonably be needed, and to what extent you can afford the risk of investment losses or of investment gains that are below expected levels,” according to EMMA, the Electronic Municipal Market Access system, which educates and informs investors about the municipal securities market. EMMA is sponsored by the Municipal Securities Rulemaking Board, a self-regulating group that aims to ensure a fair and efficient municipal market. (Today’s risk-off investors appear unlikely to use munis as one of their investments strategies against market volatility.)
Municipal bonds are issued by state and local governments to finance public projects, such as schools and bridges, and the bonds come in many forms, including long-term, fixed-rate bonds and zero-coupon bonds, according to EMMA. Municipal bonds are secured by the issuers’ promise to repay bonds either through taxation (general obligation bonds) or revenues from a facility, service or system (revenue bonds).
Municipalities can obtain bond insurance from an insurance company or a letter of credit from a bank. Bonds backed by a letter of credit may have two ratings, one based on the creditworthiness of the bank and one based on the financial strength of the bond issuer. In addition to credit risk, munis can also pose market risk, interest rate risk, liquidity risk and call risk.