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Published or updated by Miranda
One of the more popular investment strategies during tough economic times is to turn to bonds.
Bonds are considered relatively safe, when you invest in entities that are highly rated and stable. Since you are supposed to get your principal back (barring a default), plus a small amount of interest, many people like the idea of bonds.
A type of bond that has seen an increase in popularity recently is the municipal bond.
Municipal bonds are issued by localities. They often come with higher yields than Treasury securities and even many corporate bonds. On top of that, there are tax advantages to investing in municipal bonds.
But before you decide to take the plunge with municipal bonds, make sure that you understand how they work, and the types of risks involved.
General Obligation: These are bonds issued in an effort to raise revenue for various purposes. They are not attached to a specific project, and the backing is usually in the form tax revenues from local residents, or from the general fund.
Revenue: These are bonds issued with the purpose of funding a specific project. There is usually hope that the project, when complete, will generate revenues that can then be used to repay the bonds (with interest). Many non-profit organizations, including hospitals, make use of revenue bonds.
Basically, you invest in a bond, and the money is used to complete a project, or provide immediate revenue for a local government. You receive regular interest payments (that aren’t taxed by the federal government), and then you are expected to receive your principal back at the end of the term.
For those looking for higher yield, this can be an interesting choice.
However, it’s important to realize that there are still risks. Many investors think that because most municipal bonds are issued by local governments, they are “safe.” Additionally, there are also those that believe that a municipal bond issued by a college or hospital is likely to be a “sure thing.”
This isn’t the case. While many consider most municipal bonds to be reasonably secure, there are still risks.
Risks Associated with Municipal Bonds
Before you invest in anything, you should understand the risks involved. This goes for municipal bonds as well as for any other type of asset.
Some of the things to take into consideration as you decide on municipal bonds include:
Purpose of Financing
It can be comforting to buy a revenue bond with the expectation of being backed by future income for an entity. However, it’s important to take a look at the purpose of the bond. Why is the financing needed? What is the project?
It’s one thing to buy a revenue bond to finance the building of a toll system on a busy highway, and quite another to invest in bonds connected to speculative for-profit (or even not-for-profit) venture.
Make sure that you understand the project, and that you understand the feasibility of the project. If the project turns out to be a bust, you might lose money.
Non-Recourse
Check to see if the municipal bond you are investing in is non-recourse. This means that if the revenue flow trickles to a stop, you don’t have other recourse. This means that you need to be on top of the situation. If something goes wrong, you are out of luck if you have a non-recourse bond.
Stability
Don’t forget to look at the stability of the entity issuing the bond. If you are investing in general revenue bonds from a particular city, figure out if you trust the management of the city, and the stability of the city’s finances. You might be able to get a higher yield with a city that seems a little desperate, but you’ll also experience a higher risk of default.
Also, don’t forget about interest rate risk. Even though many municipal bonds offer higher yields than many other types of bonds, the yields might still be somewhat low. In some cases, your return won’t beat the rate of inflation. In that case, you lose purchasing power over time. That’s something to consider as well before you invest in municipal bonds.
About Miranda
Miranda is a freelance writer and professional blogger specializing in financial topics. Her work appears on numerous financial sites, including Wise Bread and Huffington Post. Miranda's blog is Planting Money Seeds.
Nice overview of munis Miranda! I think they can be a great tool in your portfolio, as long as they fit your need. If not, there are much better things you could be putting your money in.
This is a good balanced article with some wise “buyer beware” advice. For many years I was naive enough to think that government related investments were safe and boring. That applied to local or central government, but oh how wrong I was. In the current financial environment. Government issues do carry risk, as Miranda points out, so maybe they should be thought of risky and boring.
That is not to say that “boring” investments should not be part of a personal investment portfolio.
Glen Craigsays
I think most average investors could do well with boring. It’s the “exciting” stuff that gets us into trouble buying and selling at the wrong times.
One of the principal risks facing municipal bond investors is interest rate risk, or the risk posed to a bond as a result of interest rate fluctuations. In general, the longer the maturity of a bond, the greater the risk.
Bonds are particularly susceptible to purchasing power risk due to their fixed coupons. Investors receive a fixed amount of interest over the life of the security. If prices of everything from milk to cars to real estate rise, the fixed amount of interest now has less purchasing power (buys less).
Buying municipal bonds is low-risk, but not risk-free, as the issuer could fail to make agreed-upon interest payments or be unable to repay the principal upon maturity.
If you sit in the 35% income tax bracket and live in a state with relatively high income tax rates, then investing in municipal bonds (munis, for short) will likely be a better option than taxable bonds. Alternatively, if your income is in the 12% tax bracket, then you may want to steer clear of municipal bonds.
Municipal bonds, like all bonds, pose interest rate risk. The longer the term of the bond, the greater the risk. If interest rates rise during the term of your bond, you're losing out on a better rate. This will also cause the bond you are holding to decline in value.
Still, some leading investment managers and analysts suggest it's time for investors to come back home to municipal bonds. "After two tumultuous years, we expect a municipal market recovery in 2024," says Robert DiMella, executive managing director, co-head of MacKay Municipal Managers.
These factors include: Interest Rate Risk — the risk posed to the owner of a bond as a result of interest rate fluctuations. When interest rates rise, bond prices tend to fall; conversely, when rates decline, bond prices tend to rise.
General obligation (GO) bonds are funded directly by tax revenues. They are the safest type of municipal bond, but they often have the lowest interest rates.
Unless an investor happens to trade a municipal bond on an interest payment date, some accrued interest must be settled in the transaction, which will affect the price of the bond. Generally fixed rate municipal bonds pay interest on a semiannual basis such as on June 30 and December 31 of each year.
Municipal bonds have historically been attractive for high income earners — the exemption from federal, state and local taxes makes them a catch among the wealthy. Additionally, the asset class often provides a safe haven for high-income individuals when politicians float more levies.
Yes, you can lose money investing in bonds if the bond issuer defaults on the loan or if you sell the bond for less than you bought it for. Are bonds safe if the market crashes? Even if the stock market crashes, you aren't likely to see your bond investments take large hits.
Municipal bond yields started 2024 at their highest level since 2011. In this environment, investors may enjoy attractive total returns from income alone, a dynamic absent for almost 10 years. Municipals do not need a meaningful rate rally or dramatic spread compression to offer outsized, equity-like returns.
About 72 percent of bonds are owned by individuals directly or through mutual funds and the like. About 25 percent of bonds are owned by businesses, primarily property and casualty and life insurance companies, but also banks.
While buying individual bonds can be a good strategy for investors who plan to buy and hold until the bond's maturity date, investing in a mutual fund or ETF is the easiest and most cost-effective way to build a diversified portfolio of municipal bonds.
The five-year cumulative default rate for muni bonds was only 0.08% from 1970-2021. Global corporate bonds defaulted at 6.8% over the same time frame. What's more, many municipalities were bolstered by direct federal aid during the pandemic.
Purchasing power risk is most prevalent in fixed income securities because income from these securities is set to nominal terms. A good way to mitigate or work against purchasing power risk is to invest in equity shares because they are less susceptible to inflation.
For example, if your portfolio provides a 6% return in a year when inflation is 3% then you have beat the decline in purchasing power. Going back to our $1, let's consider the co*ke example. Say the $1 can buy a co*ke this year, but inflation is 3%, so it takes $1.03 to buy the co*ke next year.
Conventional bonds promise fixed dollar payments of interest and principal. The real value, or purchasing power, of a bond's payment is how many goods and services it can buy.
Inflation risk (sometimes referred to as purchasing power risk): Refers to the risk that inflation will diminish the buying power of an investor's assets and income. Interest rate risk: The possibility of the reduction of the value of a security, especially a bond, because of a rise in interest rates.
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