Investors alarmed by panic selling of municipal bond funds, as well as growing government deficits, are wondering whether muni bonds have lost their historic “safe-haven” role.
The answer is not a simple “yes” or “no,” experts say, since the Recession has brought some municipalities close to bankruptcy, but left others in relatively good shape. The safety of municipal bonds varies by region, type of bond and the financial health of the agency calling for credit.
An overlay of financial considerations complicate the decision to buy municipal bonds, traditionally safe investments that provide low returns but offer tax advantages. Munis appeal most to investors seeking security and to wealthy investors, who benefit from federal and some state tax breaks on interest earned. The recent selloff has also created bargain prices that appeal to investors shopping for values.
“Your overall investment strategy should be based on a number of factors, including how much risk you are willing to take, the purpose of your investment (income, growth or some of both), your investment horizon (when do you think you will need the money) and whether it’s a good fit with other investments in your portfolio,” said the Financial Industry Regulatory Agency, a self-regulatory agency, in an Investor Alert titled “Municipal Bonds – Staying on the Safe Side of the Street in Rough Times.”
Despite the recent turmoil in the bond market, munis can still play an important role in a portfolio, experts say, particularly for conservative, wealthy investors. Munis are still considered a relatively safe investment, but like all investments they do pose some risks. Muni bonds differ significantly, so wise investors will evaluate the risks and rewards presented by individual bond offerings.
“Investors considering an investment in municipal bonds should bear in mind that no two municipal bonds are created equal – and they should carefully evaluate each investment, being sure to obtain up-to-date information about both the bond and the issuer,” said FINRA in the Investor Alert it co-published with the Municipal Securities Rulemaking Board.
Investors typically choose from two common types of municipal bonds, General Obligation Bonds and Revenue Bonds. GO bonds are issued by states, cities or counties and are backed by the “full faith and credit” of the government entity issuing the bonds. The creditworthiness of GO bonds is based primarily on the economic strength of the issuer’s tax base, the Alert said.
Revenue bonds are backed by fees collected by an agency, such as road tolls, or other revenue generated by an agency. The creditworthiness of revenue bonds depends on the financial success of the project they are linked to, or on tax revenues.
“Defaults tend to be higher for revenue bonds than for GO bonds – especially those that back private-use projects, such as nursing homes, hospitals or toll roads,” said the Alert.
The main risk factor posed by municipal bonds is the ability to meet its financial obligations, so it’s prudent to consider how likely the bond issuer is to default. Investors can review the bond’s “official statement,” in which a municipality discloses its financial condition and the details of its bond. The MSRB makes these statements available to the public for free through its Electronic Municipal Market Access (EMMA) Website. Investors can also ask their brokers for disclosure statements. SEC and MSRB rules require brokerage firms to obtain up-to-date disclosures on the bonds they sell.
“Ask your broker if a bond’s issuer is up to date with its reporting of its annual financial/operating data,” the FINRA/MSRB Alert said. “Treat missing or past due financial information as a potential red flag.”
Credit ratings can help evaluate a bond’s default risk, but it’s important to realize these ratings are “estimates only” and should be only one of many factors in evaluating municipal bond investment, the Alert said.
“A high credit rating is not a seal of approval and neither reflects nor guarantees stability of market value or liquidity,” the Alert said, but a low credit rating may very well be a sign of a bond’s increased risk of default and “should not be taken lightly.”
Some muni bonds offer insurance that promises to take over payments if the bond issuer defaults, but these guarantees are only as good as the company that makes them, the Alert said.
“For this reason, when considering an insured bond be sure to take into account the credit rating and long-term viability of the bond insurers,” the Alert said, noting that the credit ratings of most bond insurers were downgraded during the Recession.
The following tips provided by FINRA/MSRB can help investors protect themselves from risk when considering municipal bonds:
• Check out the broker and the firm. A securities salesperson must be properly licensed and his or her firm must be registered with the MSRB and with FINRA, the SEC or a state securities regulator.
• High yield equals higher risk. Never make your investment decision based solely on a bond’s yield unless you are willing to assume more risk.
• Read the “official statement” prepared by the bond issuer. The disclosure contains important information, such as the bond’s yield and call date.
• Evaluate a bond’s price. Bonds can trade above or below their face value for a variety of reasons, including fluctuations in interest rates or the quality of the issuer.
• Research, research, research. Before buying any municipal bond carefully consider the financial health of the agency issuing the bond. In the case of a revenue bond, ask whether the municipality has enough revenue to make payments on the bond.
• Figure the tax angle. Run the numbers to determine whether buying a tax-free muni bond makes sense for you.
• Diversify. Risks can be lessened by diversifying among investment types and within the same asset class. Diversifying within the muni bond asset class includes issuer, location and maturity date.