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Vanguard Municipal Bond Mutual Funds

Here are some Municipal Bond Mutual Funds that we have researched for our portfolio. Also see Fidelity California Municipal Bond Mutual Funds. Research done 1/12/2012.

Morningstar’s favorite National intermediate term municipal bond fund picks and California intermediate term municipal bond fund picks.

California specific tax exempt funds

Vanguard California Intermediate Term Tax Free Fund (VCAIX)

Average maturity 5.7 years. Average duration 5.55 years. Average credit quality A. Expense ratio 0.20%, 0.12% Admiral shares. Morningstar rating 4 stars, Silver.

2011 return: 10.16%

Note: Very low expense ratio, but longer duration than Fidelity’s fund and lower average credit quality.

Vanguard California Long Term Tax Exempt Fund (VCITX)

Average maturity 7.6 years. Average duration: 6.74 Years. Average Credit quality: A. Expense Ratio: 0.20%, 0.12% Admiral shares. Morningstar Rating: 4 Star, Silver.

2011 return: 11.49%

Note: Too long the duration for us.

Comparing Fidelity and Vanguard California Intermediate Term municipal bond mutual funds. We can see the effect of longer duration net asset value fluctuations. The Vanguard fund does yield more though.

National tax exempt funds

Vanguard High-Yield Tax-Exempt Fund (VWAHX)

Average maturity 8.4 years. Average duration 6.73 years. Average credit quality BBB. Expense ratio 0.20%, 0.12% Admiral shares. Morningstar rating 4 stars, Silver.

2011 return: 10.98%

Note: Too long the duration for us and low average credit quality. This high-yield tax exempt fund can invest up to a fifth of its assets in below investment grade bonds. The other 80% must be in investment grade municipal bonds.

Vanguard Intermediate Term Tax-Exempt Fund (VWIUX)

Average maturity 5.7 years. Average duration 5.45 years. Average credit quality A. Expense ratio 0.20%, 0.12% Admiral shares. Morningstar rating 4 stars, Silver.

2011 return: 9.71%

Note: Too long the duration for us.

Vanguard Limited Term Tax-Exempt Fund (VMLTX)

Average maturity 2.8 years – Average Duration: 2.45 Years – Average Credit quality: AA. Exp Ratio: 0.20%, 0.12% Admiral shares. Morningstar Rating: 3 Star, Silver

Note: very good credit quality and duration.

Vanguard Short Term Tax-Exempt Fund (VWSTX, VWSUX)

Average maturity 1.2 years – Average Duration: 1.12 Years – Average Credit quality: AA. Exp Ratio: 0.20%, 0.12% Admiral shares. Morningstar Rating: 2 Star, Silver

Note: Very Short duration and high credit quality. Almost an enhanced  money market type fund.

Comparing Fidelity Intermediate Term and Vanguard Short Term municipal bond mutual funds. We can see the effect of longer duration net asset value fluctuations. The Fidelity fund does yield more though.

Education Municipal Bond Mutual Fund

All about Municipal Bond Mutual funds – Municipal Bond Managed Accounts

Vanguard California tax-exempt municipal bond mutual fund

One of the best ways to purchase a portfolio of Muni bonds for individual investors, is to purchase a municipal bond mutual fund.  These are funds that invest in a wide range of municipal bonds.  Mutual funds come in all sizes and specialize in different durations and locations.  There are short-term funds, intermediate and long-term funds.  The key is to read the prospectus and key in on the securities that are owned by the fund.

Just like stock funds, bond mutual funds have expenses that investors need to pay.  Some have upfront or even back end sales loads.  This is a percentage that an investor pays to the fund, just for the right to invest with the fund.  These are funds to avoid. We would also avoid mutual funds that use leverage or borrowed money. There is just too much downside risk and volatility with the use of leverage. A risk in mutual funds is the possible change in price of the fund, when everyone is heading toward the doors at one time.  The fund needs to sell bonds to meet redemption requests.

A common method of using leverage in municipal bond mutual funds involves purchasing inverse floating rate bonds or Tender Option Bond Trusts (TOBs).  Avoid funds that use these.

Mutual funds allow individuals who do not have large pocketbooks to be active in the municipal bond market.  Individual bonds are best for people prepared to invest more than $250,000 in bonds (this allows the investor the flexibility to generate a laddered portfolio that covers the range of bonds required to have a balanced portfolio.  The tax benefit for high-income households makes Muni’s attractive.

Try to find funds that do not own auction rate securities, inverse floaters, and other volatile investments. Mutual funds with larger asset bases, say over $1 billion, are more durable and times when the shareholder redemptions occur. They won’t have to sell as often, as smaller funds may have to do.

Some mutual funds also avoid the smaller and unrated municipal bonds, ones that are more prone to problems. If a mutual fund has the majority of their portfolio in unrated bonds, which have not been tested by rating’s firms, we would probably not want to own the fund. Unrated Muni bonds are usually not backed by normal Municipalities. You are relying on the fund manager’s expertise when he purchases these non-rated bonds.

The average duration of a mutual fund is an important attribute to look at, when purchasing a bond mutual fund. It is a measure of a bond fund’s sensitivity to changes in interest rates. The greater the average duration of a fund’s holdings, the more its share price will fluctuate when interest rates change. If a bond mutual fund’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 or net asset value. A 1 percentage point decline in rates would likely lead to a 2.5% rise in the share price. 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 mutual funds with shorter durations of around 2-4 years.

Keep in mind that municipal bond mutual funds usually have a high degree of correlation in pricing with U.S. Treasury bonds. They will increase or decrease in value as the bond market fluctuates (interest rate risk), even though they possess unique credit risks associated with projects, municipalities, and states.

Active municipal bond mutual fund managers continuously monitor credit risk in their portfolio and adjust to changes in interest rates. They also should look for attractively priced bonds. While the best active managers can only slightly increase performance, they should be able to minimize downside risk significantly.

Purchase municipal bond funds that hold high-quality bonds, preferably those with credit quality rated AA or better. Avoid high-yield municipal bond funds which own lower quality bonds and unrated bonds, which are more prone to default.

Owning national municipal bond mutual funds can add diversification because the bonds are purchased from any state whereas a single state municipal bond mutual fund is forced to buy bonds of just a single state. With a single state fund, there may be limited supply of municipal bonds and hence, higher prices on those bonds. There is also the possibility of higher yields. Even after paying state income tax, shareholders of a national municipal bond mutual fund may receive a better deal.

Defined maturity mutual funds

In June 2011, Fidelity launched several defined maturity municipal bond mutual funds. The funds will be liquidated on June 30 of each specific year and any remaining value will be returned to shareholders of record. These funds attempt to achieve what individual investors typically do with bond ladders, while including the versatility of a mutual fund. Holding one of these funds until maturity won’t exactly guarantee you get back the same net asset value that you paid in that. Not all bonds will mature exactly on the June 30 liquidation date, resulting in slightly lower yields as they close in on maturity. These funds charge an expense ratio of 0.40%, which is pretty reasonable.

These Fidelity municipal bond mutual funds will target 2015, 2017, 2019, and 2021 as maturity dates: Fidelity Municipal Income 2015 (FMLCX), Fidelity Municipal Income 2017 (FMIFX), Fidelity Municipal Income 2019 (FMCFX), and Fidelity Municipal Income 2021 (FOCFX).

These are brand-new funds, so I would give them time to iron out the kinks and establish a track record especially during any downdrafts.

Mutual funds screener

There are a number of great funds, each broken down into a different category covering the municipal bond markets.  Using a mutual fund screener is an efficient and intelligent way to find the best combination of criteria to match your goals. Morningstar has a very good screener, which handles most criteria.  This type of tool will allow you to ladder or diversify your portfolio through mutual funds in an efficient manner.

MorningStar municipal bond fund screener

Morningstar’s favorite National intermediate term municipal bond fund picks and California intermediate term municipal bond fund picks.

Recently municipal bond ETF’s have been issued.  These are exchange traded funds that trade like stocks, but have a portfolio of municipal bonds as their holdings.  These new ETF’s are thinly traded, and do not have a track record so we would proceed with caution.

There are Closed End bond funds that concentrate on the municipal bond market.  A Closed End fund is an investor pool, where there are a limited number of shares issued.  New shares are rarely issued after the fund is launched; shares are not normally redeemable for cash or securities until the fund liquidates. The price of a share in a closed-end fund is determined partially by the value of the investments in the fund, and partially by the premium (or discount) placed on it by the market. The total value of all the securities in the fund divided by the number of shares in the fund is called the net asset value (NAV) per share.  The NAV may differ significantly from the current price.  Many Closed End funds, which trade like stocks, utilize leverage, which creates volatility.  Additionally, many close end fund have high fees.

Managed Muni Accounts

Another way for an investor to gain access to the municipal bond market without actively managing a portfolio is to hire an account manager.  Firms such as JP Morgan, Goldman Sachs and Citi cater to high net worth clients, who usually open accounts of more than 1 million dollars.  There are muni bond managed accounts for those with a least $250,000 to invest in bonds, at brokerages such as Schwab using managers such as Pimco (0.35% expense ratio) and Nuveen (0.65% expense ratio) . Some of these managers use techniques as described in How to Perform Active Municipal Bond Management

Mutual Funds to Consider

There are many great mutual funds; some of the top firms include Fidelity, Legg Mason, Vanguard and T. Rowe Price.  Look for no-load, low expense, high credit quality mutual funds with a manager that has a solid track record. Short and intermediate-term funds are the best bets.

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

Education Individual Bond Municipal Bond

How to Select Safer Municipal Bonds

Last update July 2015
newspaper with municipal bond quotes

With over 20,000 municipal bonds in circulation, how does an investor select a municipal bond to purchase?  In our article What to Look for in a Municipal Bond , we describe some key details to look for in a municipal bond. In this article we drill down further and try to focus in on more specific attributes to look for in a safe municipal bond. This article will be updated from time to time to reflect new information we have dug up, and hopefully our readers help submit.

We have entered an era where educated bond pickers will do well, while those who blindly purchase municipal bonds, may counter issues. Obviously we would like to purchase of a municipal bond that is reasonably priced and provides the decent yield given this maturity date. Here are some specific attributes to look for in a municipal bond.

Fiscally stronger states: Arkansas, California (Avoid Central Valley), Delaware, Georgia, Maryland, North Carolina, South Carolina, Oregon, New Mexico, Minnesota, Texas, Tennessee, Virginia, and Utah are stronger than most of the other states.

Weak states include Rhode Island, Illinois, Michigan, New Jersey, New York, Nevada, and Pennsylvania. Puerto Rico is often listed as a state to avoid. An easy way to determine if state is weak is to look at its municipal bond spreads over a 10 year AAA municipal bond index. The wider the spread, probably the weaker the state. See this WSJ article for a map showing strong to weak states.

A recent analysis of states showing ones with the highest debt to GDP ratio in 2009 listed Connecticut, Hawaii, Maine, Alaska, and Oregon.

Essential Service Municipal Bonds

Obviously we should avoid general obligation bonds of these weaker states. Local projects within states need to be scrutinized carefully to ensure that essential services are backing these municipal bonds. Beware of water and other services requiring multiple agreements between different providers, these interconnections can lead to uncertainty and other problems. Is just a handful of customers paying for the services? Newly developed communities may have essential services that are much weaker than established communities. Weaker states and projects have to pay higher interest rates to attract investors, so try to avoid the temptation of chasing yield. We want to definitely diversify geographically. Only buy senior debt of essential services, as they have a better chance to be paid should problems arise.

47% of municipal bonds at the end of 2010 were tax secured, 13% are utility, 11% are US government, 9% for transportation, 9% are in healthcare, 5% or higher education, 3% are corporate backed, 1% our project finance, and the balance were Other.

14% of municipal bonds were state general obligation bonds, 10% were local general obligation bonds, 11% were insured bonds, and 9% were pre-refunded municipal bonds. 12% were transportation revenue bonds, 9% for special tax bonds, 7% were hospital bonds, 7% were water and sewer bonds, 6% were education, 5% were electric utilities, 4% were for leasing, with the balance in housing and resource recovery.

Be sure to read our article Analyzing Municipal bond Defaults

Also Avoid:

  • Pension Obligation Bonds

Seasonality

And increase supply in municipal bonds typically occurs from March to June, while a slowdown in the issuance occurs usually from December through January.

Attributes to avoid

Tobacco bonds because smoking rates are falling, possibly causing revenue assumptions not to be met, making default possible in the future.

PIK bonds, interest rate swaps, sub debt, bonds financed by property taxes, bonds financing assisted-living, and unrated municipal bonds.

If you buy mutual funds, avoid ones with low average credit quality, too long a duration, and ones that use leverage.

Attributes to look for

General obligation bonds of fiscally strong states, essential service bonds, pre-refunded bonds Backed by or escrowed by US Treasuries. Make sure they are escrowed with US Treasurys, not Fannie Maes, not Freddie Macs, not Guaranteed Investment Contracts–GICS. You can verify this by entering the bonds CUSIP number on MSRB.org

Insurance is no longer that important as less than 10% of bonds are now insured. There are no longer any AAA rated insurers to back municipal bonds like there were in the past. So the key is to look at the underlying rating of the bond, while ignoring insurance.

Look for bonds with high ratings from S&P, Moody’s, or Fitch. Most people define AAA or AA rated bonds to be the best bet. At the end of 2010, 20% of municipal bonds are rated AAA, 47% are AA, 25% are A, 6% are BBB, and 2% are below investment grade. Avoid unrated bonds and lower quality bonds.

Premium bonds are preferred. These are bonds that trade at a level above par or 100. If you purchase a discount bond, you have to pay income tax on the discount amount. With premium bonds you’ll get greater income, less volatility, but you will have to pay more in the beginning.

Those taxpayers affected by AMT should look for municipal bonds that are not subject to the AMT tax.

Kicker Municipal Bonds

As interest rates have fallen, investors seek to gain more yield. They are turning to a type of investment known as kicker bonds or cushion bonds.

  • Kicker bonds can be called sooner and unexpectedly
  • They sell at a premium
  • Income can be double that of regular municipal bonds
  • There is the potential for extra reward down the road
  • They accounted for almost 63% of the Municipal Bond Index in 2012, up from 30% in 2011
  • Downside occurs if the bond is paid back early
  • If they are not called early, you keep earning the high interest rate

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

Education Individual Bond Municipal Bond Regulatory

Why Municipal Bonds are Bad Investments

San Francisco, Golden gate Park, windmill

Municipal Bonds Today.com is dedicated to helping investors demystified the municipal bond market place, so what better than to have an article describing reasons why municipal bonds are a bad investment.  We need to understand the dark side of municipal bond investing to realize areas we need to avoid.

Revenue Challenge

Revenue from sales tax, income tax, and property taxes are falling, so municipalities are encountering hard times and may default more often than the past. Towns and cities often rely on one fourth of their revenue from property taxes. One third of their revenue typically comes from state aid, according to the Congressional Budget Office. The credit crisis, unemployment, foreclosures, and the like are impacting the ability to meet obligations. Many local governments have major financial problems, and need to work out their problems without borrowing more money. Analyst Meredith Whitney explains the situation in this video. Stimulus funds run out in June 2011, so a day of reckoning is close at hand.

States have increasingly relied on issuing new debt to pay their bills, rather than increasing taxes or cutting spending.

Tobacco Issues

Tobacco bonds are backed by payments made to the state government by tobacco companies. These statements are based on projected cigarette sales. The problem is that cigarette consumption keeps dropping, making the original projections way out of whack. This leads to fears that defaults could occur.

Failed projects leads to bond Defaults

Revenue bonds on projects with an ample amount of risk are failing. Key examples of failed projects include Wisconsin‘s steam plants, Las Vegas monorail, and non-hospital healthcare facilities. If you go back and look at the Official Documents, you can see that there projections a.k.a. guesses were way off, and bond insurance has amounted to little insurance.

Underfunded Pension Liability

There are many states with massively underfunded pensions. These long-term liabilities are usually not on the balance sheet and hidden away from most investors. It is estimated that $11 trillion is the amount nationwide that is underfunded. But, 84% of state pensions were funded, in aggregate. This is a serious long-term issue that needs to get addressed. Official Statement‘s need to get beefed-up to acknowledge these liabilities. Municipalities have to raise taxes, increase retirement age, and cut services to bridge the pension liability gap. At least this liability is not a near term causer of default risk.

Additionally some states have underfunded Unemployment Funds.

No AAA Rated Insurers

Municipal bond insurance used to be incredibly important, but now that there are no more AAA-Rated insurance companies, fewer than 10% of bonds get insured. Credit ratings of the underlying security are much more important now.

City/State Budget Gaps

Many large states and cities are running huge budget gaps. Expenditures far exceed revenues, something that doesn’t work very long. $350 billion is the projected gap for 2010 and 2011. Illinois has a 42% gap, while California has a 22% gap. Something needs to be done to stop the hemorrhaging. The health of local governments usually lags the national economy by a year or two.

Desperate Municipalities Selling Assets

To plug huge deficits, municipalities are starting to sell off physical assets like real estate. Many cities are exploring selling buildings and then leasing them back. The key is to make sure that the lease service funds have been appropriated, or else a bigger hole will emerge for them.

Substandard Disclosure

There have been several cases of lawsuits against local governments claiming that the government misled investors when making a bond offering. New Jersey and San Diego, in 2010, got sued for failing to fully disclose their pension liability. The SEC is investigating the area and will hopefully add more disclosure requirements to municipal bonds. A municipal bond unit was set up by the SEC in 2010 tasked with ensuring that information was disclosed to bondholders in a timely fashion.

In the middle of 2012, the SEC asked Congress for the authority to fix the problems with municipalities who issue bonds but don’t keep the public up to date on their financial situation. They would like to allow intermediaries to sue the municipality when disclosures are breached.

Audited financial statements could be wrong. Municipal auditors engage in peer review process, something that was used during Enron’s era. Accounting standards differ in need to be standardized. Random Federal Audits in 2007 no problems relating to internal controls in many municipalities.

Investors must wait a year or more to see updated financial statements for cities, states, and others. By that time the financial condition may have changed drastically. A recent study showed that 56% of bond issues from 2005 through 2009 filed no financial statements in any given year. This means that more than $2 trillion of the $3 trillion in outstanding municipal bonds had insufficient ongoing disclosure.  There some instances where municipal bond investors have gotten little or no disclosure prior to a default.

Conduit Financing

Conduit Financing is where private or nonprofits use the municipal bond market for funding. The public issuer gets fees for helping the firm do it, but incurs no legal or financial liability. These are typically unrated municipal bonds that make up approximately 30% of the marketplace, but produce 35% of municipal bond defaults. Another Problem Is That the Government loses out of tax revenue.

Letters of credit

Does the state or local government have a letter of credit with a bank? When does it expire, how likely is it to be renewed by the bank. If a bank failed to renew letters of credit, then the municipal bond would need to be refinanced, causing problems.

Adjustable Rate debt

Some cities and towns in 2011 have been affected by the Greek debt crisis. They took part in municipal bond deals backed by Dexia, a Belgian French bank with large exposure to  Greek government debt. The bank had previously offered cheap financing by agreeing to backstop their municipal bonds, but the bank is now forced to increase the interest rate the cities pay, causing substantial problems.

Interest Rate Swaps

Does the state or local government have any interest rate swap agreements that they set up to try to limit interest rate risk? It is possible that interest rates will move against the swaps, causing possible problems.

Poor Regulatory Framework

The SEC can pursue violations of security law, regulate underwriters, and regulate sellers of municipal bonds. It can require them to demand financial disclosure from issuers. It cannot do this today to issuers directly. The Tower Amendment, adopted in 1975, forbids the SEC from requiring states or local governments to file information with it. This amendment arose to prevent Federal government from impinging on state sovereignty. Considering any major problem in the municipal bond market would eventually fall on the Federal government anyway, this law is out of date. The SEC can only go after broker dealers that commit fraud. Clearly the SEC’s power needs to be extended.

Bond Rating Agencies

Moody’s, the rating agency, has 120 people analyzing 29,000 issuers. Clearly they only can do so much work every day. The issuers need far more scrutiny on a continual basis. Also recall how many failing securities had AAA ratings right before the credit crisis.

Doomsday scenario

A default by a state or major municipality could have unforeseen effects to the credit markets.  It is possible that the ripple effect could cause another credit crisis.

Federal Reserve bailout

Keep in mind that the Federal Reserve is limited by law to only buying certain kinds of very short term Muni debt with maturities no more than six months, so bailouts are limited. They could possibly use emergency powers to buy longer maturity municipal bonds,  if there is enough political will.

State Bankruptcies

Currently, states cannot file for chapter 9 bankruptcy, making it difficult for states to terminate costly contracts, restructure bond debt, and to redo expensive Cadillac pension benefits promised to state workers. Some cities and counties can file for bankruptcy although 26 states prevented. Keep in mind that when municipalities file for bankruptcy, only elements like interest payments can see some relief, making it not a foolproof way to solve larger problems.

Related Municipal Bond articles:

Analyzing Municipal Bond Defaults

Are we in a bond bubble?

Municipal Bonds are Bad Investments

Municipal Bonds Are a Good Investment

Education Individual Bond Municipal Bond Mutual Fund

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