What You Should Know About Municipal Bonds

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News stories can create inaccurate impressions for even the most informed investors. Municipal bonds have been in the hot seat for years, revealing problems in Detroit and now Puerto Rico. A former friend once advised me not to confuse him with the facts! Market indicators suggest that now may be a good time for some investors to reconsider municipal bonds.

Keep in mind that investors buy municipal bonds for the tax-free income; but many investors aren’t in tax brackets that justify these purchases. Many times, investors who are in the 15% marginal bracket or lower, are better off purchasing taxable bonds and paying the taxes because the coupons payments are higher than what the tax free income would net.

Bonds come in all shapes and sizes and bear several risks investors need to be aware of from the beginning.  We can’t cover them all here, but following are a few key considerations. First, individual bonds are liquid instruments that may not precisely equate to the value on the account holder’s statement.  The value reflected on a statement works similarly to a home’s appraisal. You can obtain an estimate of your home’s worth based on other home sales in your neighborhood. But an appraisal doesn’t assure you will get that price. The same holds true for your individual bonds.

Also, consider the credit risk associated with the likelihood you will get your money back at maturity. This is where the facts really shocked me. There are over 116,000 issuing municipalities in the United States. I would have missed that for certain. But only 20,000 of these issuing municipalities are rated by rating agencies.  Another big surprise!

Credit agencies examine the financials of issuing communities to determine the credit quality. This practice applies to both general obligation as well as revenue obligation bonds. General obligations are backed by the full faith and credit of the taxing community while revenue bonds are based on the income derived from the project. Revenue bonds can also represent “essential services” like sewers.  The coupon is set based on the credit rating provided by the agency and prevailing rates at the time. The higher the risk of default, the higher the coupon must be.

Rating agencies were deemed to be asleep at the wheel during the Great Recession and we may have another issue in the works. Last year was the first time since 2008 that there were more municipal upgrades rather than downgrades. The agencies are supposed to operate objectively, looking at the financial facts rather than the ugly headlines. But the facts indicate they are missing something.

When we look at the credit ratings for Baa/BBB bonds on the corporate side of the equation, we find the current default rate at 4.06%. On the municipal front the default rate drops to .75% for the same credit rating. That notable difference has nothing to do with the type of bond, but is simply based on the rating agencies’ financial numbers.

 

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column offset=”vc_hidden-lg vc_hidden-md vc_hidden-sm”][vc_widget_sidebar sidebar_id=”sidebar-main”][/vc_column][/vc_row]

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