Municipal Bonds - Risks and Other Considerations

Municipal Bond Fraud, Negligence, Breach of Fiduciary Duty and Negligent Supervision FINRA Arbitration and Litigation Attorney, Russell L. Forkey, Esq.

There are multiple  categories of investment vehicles available in the market place.  Once such category is municipal bonds.  What are they and what risks are associated with them?  In this post, we have attempted to answer some of these questions.  Please keep in mind that this information is being provided for educational purposes only.  It is not designed to be complete in all material respects.  Thus, it should not be relied upon as providing legal or investment advice.  If you have any questions concerning this post, please contact a qualified professional.

What are municipal bonds?

Municipal bonds are debt securities issued by states, cities, counties and other governmental entities to finance capital projects, such as building schools, highways or sewer systems, and to fund day-to-day obligations. Investors who buy municipal bonds are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or "principal." The date when the issuer repays the principal, the bond's maturity date, may be years in the future. Short-term bonds mature in one to three years, while long-term bonds won't mature for more than a decade.

Benefits to investors in municipal bonds include the fact that interest on such bonds generally is exempt from federal income tax and may also be exempt from state and local taxes for residents in the state where the bond is issued. Given the tax benefits, the interest on municipal bonds is usually lower than on taxable fixed-income securities such as corporate bonds.

The two most common types of municipal bonds are general obligation bonds and revenue bonds:

  • General obligation bonds are issued by states, cities or counties and not secured by any assets; instead, they are backed by the "full faith and credit" of the issuer, which has the power to tax residents to pay bondholders.
  • Revenue bonds are not backed by government's taxing power but by revenues from a specific project or source, such as highway tolls or lease fees. Revenue bonds usually are non-recourse, meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source.

In addition, municipal borrowers sometimes issue bonds on behalf of private entities such as non-profit colleges or hospitals. These "conduit" borrowers typically agree to repay the issuer, who pays the interest and principal on the bonds. In cases where the conduit borrower fails to make a payment, the issuer usually is not required to pay the bondholders. Recently, many municipalities also began to issue taxable Build America Bonds and other taxable municipal bonds with associated tax credits or direct federal payments to the issuer that were authorized by the American Recovery and Reinvestment Act of 2009.

Individual investors hold about two-thirds of the roughly $2.8 trillion of U.S. municipal bonds outstanding, either directly or indirectly through mutual funds and other investments. Bond investors typically are seeking a steady stream of income payments, and compared to stock investors, they may be more risk-averse and more focused on preserving rather than accumulating wealth.

What are the risks of investing in municipal bonds?

As with any investment, investors who buy municipal bonds face a number of risks, including:

Call risk. Call risk refers to the potential for a bond issuer to retire a bond before its maturity date, something that an issuer may do if interest rates decline -- much as a homeowner might refinance a mortgage loan to benefit from lower interest rates. A callable municipal bond allows the issuer to redeem some or all of the outstanding municipal bonds on or after a specified "call date" before the specified maturity date. The price the municipality pays for called municipal bonds is predetermined and may include a premium. Bond calls are less likely when interest rates are stable or moving higher. Many municipal bonds are "callable," so investors who want to hold a municipal bond to maturity should research the bond's call provisions before making a purchase. Investors wishing to research municipal bonds may access disclosure documents and real-time price data online free of charge at the Municipal Securities Rulemaking Board's Electronic Municipal Market Access (EMMA) website.

Credit risk. This is the risk that the bond issuer may experience financial problems that make it difficult or impossible to pay interest and principal in full. Defaults can more commonly occur with conduit borrowers that finance projects by borrowing through a municipal issuer. A handful of municipal borrowers also have run into trouble, as in the recent case of Jefferson County, Alabama, which defaulted on payments on $3.8 billion of sewer bonds in 2008, when complex interest rate swap agreements increased the county's debt load beyond what the county could cover. Recent economic weakness has reduced states' revenues from taxes while increasing outlays for social insurance programs, straining budgets. The need to fund public pension plans could increase financial pressure on municipal borrowers, thus raising credit risk for bondholders.

Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. It also can lead to higher interest rates and lower bond prices.

Interest rate risk. Bonds have a fixed face value, known as the "par" value. If bonds are held to maturity, the investor will receive the face value amount back, plus interest that may be set at a fixed or floating rate. The bond's price will move up as interest rates move down and it will decline as interest rates rise, so that the market value of the bond may be more or less than the par value. U.S. interest rates have been low for some time. If they move higher, investors who hold a fixed-rate municipal bond and try to sell it before it matures could lose money. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will pay a higher rate of interest than the older ones.

Liquidity risk. This refers to the risk that investors won't find an active market for the municipal bond, potentially preventing them from buying or selling when they want and making pricing more difficult. Many investors buy municipal bonds to hold them rather than to trade them, so the market for a particular bond may not be especially liquid and quoted prices for the same bond may differ. Investors can access real-time price data at no charge and see how their municipal bonds or similar bonds have traded recently at the Municipal Securities Rulemaking Board's EMMA website at www.emma.msrb.org. Recent price information may not be available for bonds that do not trade frequently.