What are the risks of investing in municipal bonds?
As with any investment, investors who buy municipal bonds face a number of risks. The purpose of this post is to provide a general discussion of some of these risks. The post is being provided for educational purposes only and 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 the below information, you should contact a qualified professional.
General risks, include:
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.