Investing in the Municipal Bond Market

Investors looking to gear their portfolios toward capital preservation with some return, rather than higher-risk capital appreciation in the stock market alone, often turn to municipal bonds.

The muni bond market is big — and growing. According to industry statistics, the U.S. municipal bond market contracted to $3.7 trillion in late 2014, down slightly from its market peak of $3.77 trillion in 2010.

Growth of the U.S. Municipal Bond Market (From the U.S. Securities and Exchange Commission)

• In 1945, there was less than $20 billion of municipal debt outstanding.
• In 1960, there was $66 billion of municipal debt outstanding.
• In 1981, there was $361 billion of municipal debt outstanding.
• Today, investors hold approximately $3.7 trillion of municipal debt.

Muni Bonds Defined

Municipal bonds are debt instruments issued by city and local governments to raise money for capital investment in local projects such as schools, streets and highways, bridges, hospitals, public housing, and utilities.

They offer investors interest that is paid at either a fixed or a variable rate, depending on the terms of the bond.

The bond issuer receives a cash payment from the investor in return for agreeing to pay the scheduled rate of interest to the investor (i.e., the bond holder). That interest is paid over a specific timetable that can stretch from several months to 40 years or longer.

Once the bond matures, the bondholder is fully reimbursed for the face value of the bond.

Types of Municipal Bonds

There are several municipal bond categories available on the fixed-income marketplace:

General obligation bonds are the direct debts of a state or local government entity and are backed by the issuer’s full faith and credit.

Historically, general obligation bonds issued by states have shown a negligible default risk. A small number of cities and towns have defaulted on general obligation debt over the years, but bondholder losses have been relatively small in comparison to the overall market, and recovery values have tended to be higher than for revenue bonds.

Revenue bonds are bonds tied to a particular project or agency. Revenue may come from a specified tax, a particular user fee or toll, or a lease payment.

Revenue bonds tied to commercial projects may carry additional risks if a tenant in the project becomes bankrupt.

Assessment Bonds obligate repayment from property tax assessment within the municipality.

Of the different municipal bond categories, GO bonds usually offer the lowest risk, primarily as they are backed by governments with the ability to levy taxes.

Although there have been isolated instances of defaults in U.S. municipalities, with being Detroit perhaps the most prominent example, governments are, by and large, mostly stable and less risky when it comes to repaying debt obligations.

Revenue bonds may offer higher risk than general obligation bonds because repayment depends on specific revenue streams rather than tax revenues, including user fees or lease payments that are vulnerable to economic trends.

Revenue bonds are also issued regularly by non-governmental entities with no backing by government agencies, and they offer no safety net for bondholders in the event of a default.

Municipal Bond “Pros”

The benefits of municipal bonds are myriad. First and foremost, they offer tax-free, compound growth with a high degree of liquidity, providing investment security to investors at any stage of their lives.

Here are some other benefits linked to municipal bonds:

• No federal taxes — Uncle Sam can’t get his hands on tax money if it’s stashed away in a municipal bond or bond fond, and that’s a big advantage for investors either in a high tax bracket or seeking a tax-exempt income stream for retirement.

• No state and local taxes — On the state and local levels, municipal bonds also offer tax protection, as most investments at these levels are exempt from state and local taxes in addition to federal taxes.

• Compound growth and steady income — Municipal bonds also give investors access to compound growth, especially if income is reinvested.

• Safer and more stable — Municipal bonds offer more stability than equity investments, while also providing tax-exempt returns and a generally much better return on invested capital than other fixed-income investments like U.S Treasuries or bank certificates of deposit.

Municipal Bond “Cons”

• May not beat inflation — While municipal bonds may beat Treasuries and CDs on return performance, in many cases, they may not beat the rate of inflation, thus negating long-term wealth creation. By a significant margin in historical terms, stocks outperform municipal bonds in rates of return and offer a much better opportunity to beat inflation.

• Risk of default — The subprime mortgage crisis collapsed on municipal bond investors, with many issuances resulting in default and with no insurance to back those losses up. According to industry statistics, in 2011, only 5.5% of municipal bonds carried insurance. According to the Federal Reserve, in 2012, municipal bond defaults in the past 40 years were 36 times more numerous than first thought. That’s a big problem with some municipal bonds — they aren’t generally insured and offer more risk than investors might think.

Consequently, municipal bonds can and do fail, leaving investors with little or no return on their investment. Moody’s Investors Service lists several recent municipal bond failures in recent years:

• $3.47 billion, Jefferson County, Alabama: The county’s sewer revenue bonds went into default, and the general obligation bonds soon followed.

• $2.25 billion, Washington State: Bonds issued to finance a nuclear power plant defaulted. Bondholders recovered about 40% of their principal and interest nearly 10 years later.

• $439 million, Las Vegas: Muni bonds that supported the monorail defaulted due to mechanical problems and lack of ridership. Subsequently, the company that insured the bonds (Ambac) filed for bankruptcy, raising the question about the solvency of other bond insurers.

• $341 million, Stockton, California: Because of a lack of fiscal stewardship, the city filed for bankruptcy last year. Some of the bonds are “backed” by insurance, but the city has requested bondholders shoulder some of the uninsured losses.

• $262 million, Harrisburg, Pennsylvania: The state capital fell into default when it failed to honor payment guarantees on a troubled incinerator project.

Despite these failures, the takeaway here is that municipal bonds have a steady, sustained track record of investment performance that, along with reduced levels of risk and volatility, can offer a dose of stability, balance, and diversity to any investment portfolio.

Until next time,

Brian O’Connell for Wealth Daily