A carefully selected municipal bond – debt issued by a state or local government – can offer security, income and tax advantages, but every investment carries risks. Investors considering adding munis to their portfolios should evaluate potential downsides, which fall into the following broad categories:
1. Headline risk. The events of late 2010 and early 2011 – when negative press stirred panic over munis – show that headline risk can be significant in the mutual bond fund market. Massive redemptions can devastate municipal bond funds, and reduce the liquidity of individually held bonds.
2. Risk of the ability of the issuer to pay back the loan. “Is that state or local government going to be there to pay that credit back,” said Brian King, product sales specialist for the investment firm Gannett, Welsh & Kotler LLC. “That is the big concern.” Investors can protect themselves from this risk by researching the financial health of the borrower. “If you’ve done your credit homework, you know you’re getting 100 cents back on the dollar,” said King.
3. Interest rate risk. The value of a bond is linked to the interest it pays on the debt. When interest rates rise, bonds yielding a lower rate lose value. Investors who hold bonds with lower interest rates must discount the products to sell them at times of higher interest rates. It’s important to note, however, that bonds held to maturity will repay the original investment. “Bonds have a terminal value,” King said.
4. Liquidity risk. The municipal bond market offers less liquidity than other markets. Fifty to 60 percent of bonds are only sold once, and many bonds can go one to two years without trading, King said.
5. Reinvestment risk. Low interest rates can hamstring investors who reinvest bonds to accumulate interest. Long-term compounding of low interest rates undermines retirement planning and becomes a great concern as investors live longer. “Someone who is 65 today may very well live to be 100,” King said.