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Municipal Bond Investing

Written By Brian Hicks

Posted October 25, 2013

The municipal bond market has been one of the safest investments for years. People never doubted bonds before. That is, until now.

The glory days of bonds are unfortunately over. People are nervous about them, and who can blame them?

But that doesn’t mean you shouldn’t invest in them. Allow me to explain.

DetroitMunicipal bonds are loans investors give to the local government. When someone buys a muni bond, he provides money to help build roads, schools, and other infrastructure in the local area. In return for this local investment, the government sends him interest payments and then the principal on a certain date.

People invest in municipal bonds because they are a good way to diversify portfolios. The stock market is volatile, and bonds are stable because they are usually held by individual investors who wait until maturity to cash in. They have a higher yield than Treasuries, too. And the cherry on top of these benefits is that they don’t carry interest rate risk.

People have felt good about municipal bonds because even if the local government ends up low on cash, they know taxes will just be increased to make up the money to pay investors. If the government defaults, bond investors are usually the first to be paid, which means losing money is nearly impossible.

Hold on to that word…nearly.

And Now…The Problems

There are problems with the municipal bond market now, despite all of the benefits. Detroit’s bankruptcy could end up costing everyone their money. If the court relieves the city of its debt, it won’t have to pay bond investors. Investors lose out on all of their money.

Puerto Rico is a problem too. Its fiscal issues with not being able to fund pension liability is making people nervous who have invested in the muni bond market, worth $4 trillion. The S&P Municipal Bond Puerto Rico Index was down 21% for the year ending October 10th.

These two places are the worst for municipal bond investing. Not only are people avoiding these bonds like the plague, but the sheer thought that investors still in them will not be able to get the money they are owed is frightening.

And there are more problems with municipal bonds affecting other parts of the country. The Federal Reserve has been threatening to do something about its stimulus for months now. If it decides to taper the purchase of Treasury bonds, it could result in increases of interest rates. While this shouldn’t affect bonds, it will affect investors who start to run away from them. When investors back out of their bonds, they end up driving the value down.

When the value of bonds decreases, it hurts everyone. Those with high yield bonds, as well as ETF and mutual fund investors, end up losing money.

Should You Invest in Bonds?

Municipal bonds aren’t a good investment right now, with all of the uncertainties surrounding them. Detroit has yet to finish its bankruptcy case. If it ends up having to pay bond investors, that will be a good thing, but if it doesn’t, it’s going to send the bond market even further down. People will lose confidence in the bond market, and they won’t want to invest in it. They would rather invest in the stock market, which may seem like a lower risk. 

If the court decides Detroit will have to keep its financial obligations, it will reinstate confidence in the municipal bond market. Investors have long felt nothing would happen to their bond investments, and that feeling will come back if nothing does happen. 

If the Federal Reserve decides to carry through its stimulus well into 2014, you’ll see interest rates stabilize or decrease. This will also calm bond investor fears, which will send more of them to the market, driving up the value.

So let’s put it all together: Wait for now. Pay attention to what happens with Detroit and Puerto Rico. If the results end up being in favor of bond investors, consider investing.

If you’re still not confident, wait a little longer to find out what the Federal Reserve is going to do. An unemployment rate of 7% is a signal the Fed may taper, so look for that as well. With all of these factors, you’ll have a good idea of when it’s a good time to jump back into municipal bonds.


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