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The Risks of Owning Municipal Bonds

municipal bonds

The bond markets are an excellent place for most investors to invest capital and generate consistent returns.  Like any capital market, bonds are not without risks.  For municipal bonds, investors need to concern themselves with inflation, defaults, ratings downgrades, material events, liquidity issues, budget woes, spending cuts, and unfunded pensions and unemployment funds.  Each of these issues can erode the value of municipal bonds.  Since bond prices fluctuate on a daily basis, it is important to become aware of few factors.

The primary risks in municipal bond investing:

  • Income Risk – The problem caused by reduced income from bonds due to falling interest rates.
  • Interest Rate Risk – When bond prices decline due to rising interest rates.
  • Call Risk – In periods of falling interest rates, bonds with a Callable option may be redeemed before they mature, reducing price appreciation potential.
  • Credit Risk – If a bond issuer has financial problems, a credit rating agency may downgrade the bond, causing its value to decrease.
  • Liquidity Risk – If markets are in turmoil, their is a chance that no one will want to purchase a security.
  • Manager Risk – The mutual fund manager may select risky investments that cause under performance.

Inflation:

Inflation is a rise in the prices of goods and services over a period.  Inflation is also erosion in the purchasing power of money.  With everything remaining the same, an increase in prices, hurts a consumer’s ability to purchase goods and services.  In general, inflation is measure by a basket of goods.  The recognized gauge of inflation is the consumer price index.

Since municipal bonds are fixed income products, when inflation moves higher, the real purchasing power of money (or fixed income) is reduced.  Therefore, when inflation ticks higher, bond investors generally reduce the amount they are willing to pay for a given bond, and demand more interest.

Investors can follow some general rules of thumb as it relates to bond prices, interest rates and inflation.

Price       Duration   Change in Rates      Change in Price     New Price

$100       10 years             1%                  -10%                        $90

$100        4 Years             1%                    -4%                         $96

$100        3 Months          1%                  -0.25                         $99.75

The average duration of a municipal bond is an important attribute to look at, when purchasing a bond. It is a measure of a bond sensitivity to changes in interest rates. The greater the average duration of a bond, the more its share price will fluctuate when interest rates change. If a bond’s average duration is 2.5 years, a 1 percentage point rise in interest rates would lead to an estimated 2.5% decline in the share price. A 1 percentage point decline in rates would likely lead to a 2.5% rise. Increase your duration if you think interest rates will fall or deflation will occur. Reduce your duration if you believe interest rates are rising and inflation is occurring. In a rising interest rate environment, investors may want to hold bond with shorter durations of around 2-4 years.

There have been a number of articles recently written about the perils of owning municipal bonds.  A recent article in the Wall Street Journal compared issues that the municipal bond market is facing to issues faced in the housing markets to sub price debt.  The article mentions that the greatest default risk is in small municipalities with over leveraged projects buffeted by the recession. Those places also might need to access credit markets less in the future than big cities, making it easier to walk away from their debt than paying you back.

Monitoring the news and determining the effect on your portfolio is important for active bond investors.  A passive investor still needs monitor markets movements since about 96% of Muni bonds experience credit rating changes within a 10 year period.

Downgrades and Super Downgrades

Bonds are only reviewed periodically by the big ratings agencies, so there is a chance the credit worthiness has slipped between evaluations.  This can lead to super downgrades where the bond is lowered in quality several notches at once.  A bond’s value would probably slip when this occurs. Some fund managers maybe forced to sell the bond due to its lower quality.

How defaults affect bonds

The municipal bond sector has had a solid record of accomplishment when it comes to the magnitude and frequency of defaults.  Defaults are times when a municipality cannot pay its debts and misses a payment or seeks bankruptcy protection.  Currently, states cannot file for chapter 9 bankruptcy. Some cities and counties can file for bankruptcy although 26 states prevented. Municipal bonds are considered the second safest category following securities issued by the Federal Government.  In the event of a default, bondholders seldom lose their entire principal. Often, a default could result in the suspension of the coupon payment, or a delayed payment.  California General Obligation bonds are second in line for payment, just after education.

While cities can and do file for bankruptcy, they are unable to liquidate or be forced to repay debts like a company. Oftentimes municipal bankruptcies take years to become resolved. In the meantime debt repayment is put on hold.

Municipalities or projects that produce late financial statements are more likely to default. Look for bonds with material events or ME flags as warning signs. Unfortunately material event notifications can occur months after the event, and there is no consequence for failing to report material events. And enforcement system should exist. You can look up material events for a specific bond on msrb.org by entering its CUSIP number and clicking on Continuing disclosureMaterial event notices. Also use the EMMA System Alerts feature to stay up to date on any important disclosures.

History of Defaults:

Default rates, varied significantly across municipal sub-sectors, even though the overall rate was low compared too many fixed-income sectors. A study perform by Fitch study found that the 16 to 23 year cumulative default rates for tax-backed and traditional revenue bonds were less than 0.25 percent. Industrial revenue bonds had a cumulative default rate of 14.62 percent, multi-family housing 5.72 percent, and non-hospital related healthcare 17.03 percent. These three sectors accounted for 8 percent of all bonds issued but 56 percent of defaults. Education and general-purpose sector bonds accounted for 46 percent of issuance but only 13 percent of defaults.

One of the new findings in the 2003 study was that there was a moderate correlation of default risk with economic cycles, though a one-year lag produced a higher correlation. During the early 1980s and the early 1990s when economic growth was slow, default rates were the highest.

A December, 2010 report from Bank of America Merrill Lynch indicated that there was $4.25 billion of municipal debt in default, representing only 0.15% of the entire municipal bond market.

Another new finding was that defaulted municipal bonds have a high recovery rate of 68.33 percent based on the number of defaults. Recovery can be made in a couple of ways. The borrower may get out of the default situation by making full debt service payments or forfeiting collateral securing the bonds may be liquidated. Most issuers, particularly providers of essential services such as water and sewer, eventually resume paying debt service.  Make sure that not just a handful of customers are paying for the essential services. They are never pledged to bondholders. In such cases, bondholders maintain a lien on revenues, which often enables full recovery. Industrial development bonds and multifamily housing bonds, the two sectors with the highest default rates, are often backed by collateral leading to higher than average recovery rates.

Read:

Analyzing Municipal Bond Defaults for additional information.

Bond insurers

The key to successful municipal bond investing is to perform the due diligence needed to find a solid investment.  It is no different than finding a solid stock.  Prior to the recent credit crises, municipalities could purchase insurance for bonds, but AAA insurers no longer exist today, to back up bonds.

Recently in 2010, bond insurer Ambac moved into Chapter 11 and is no longer rated by credit reporting agencies, because it believes the IRS would gut the entire company. Municipal bond insurer FGIC is also in Chapter 11. Assured Guaranty is also having financial difficulty, their rating has fallen to a AA- as of 2012. MBIA has fallen to a B- rating, which is below investment grade. Their subsidiary National Public Finance Corp. is rated BBB. Because the number of insured Muni’s has fallen to about 7%, the municipal bond market has become more fragmented with 20,000+ bond issues needing to be carefully scrutinized for risk. There are now very few mutual funds that predominately hold insured municipal bonds, due to their scarcity.

Recent problems in the industry include some shortfalls of full disclosure.  An example in 2010 was San Diego failed to disclose underfunding pensions in bond offering disclosures (penalties were paid by San Diego).  The SEC may impose more penalties or require more disclosure, as there is not enough money to repay bondholders if failure occurs.

State Budget Problems

Sometimes the volatile stock market causes problems for state budget planners. The assumptions they have made in regards to personal income tax collection are heavily affected by stock market returns and taxes collected from wealthy individuals. State budget prospects may become more gloomy due to a declining stock market, forcing states to pare back on their budgets.

Additional Related Municipal Bond Educational Articles:

What are municipal bonds?
How to Research Municipal Bonds
The Risks of Owning Municipal Bonds
How to Buy And Sell Municipal Bonds
Municipal Bond Mutual funds – Municipal Bond Managed Accounts
What Are Closed-end Municipal Bond Funds?

What are Municipal Bond Exchange Traded Funds or ETFs
How to Make a Municipal Bond Ladder
How to Select Municipal Bonds
Municipal Bond Trading Example
How to Perform Active Municipal Bond Management
Municipal Bond Books and Educational Resources

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