Intro: Are Municipal Bonds a Good Investment (Investing in Muni Bonds)
Municipal bonds, or “munis,” a $3.7 trillion market in the U.S., are attractive to many investors, not least because interest income earned is exempt from federal income taxation and, depending on specific circumstance, from state and local taxes, too.
For some, another positive afforded by municipal bonds investing is the opportunity to support local projects that benefit the public good, such as hospitals, road-building, and schools. But are municipal bonds a good investment in 2017? And, for anyone wondering how to buy municipal bonds, what are the factors that should be taken into consideration?
This article by AdvisoryHQ looks at some of the advantages, disadvantages, and risks for those considering investing in municipal bonds. After a brief overview of the types of investments on offer, we provide guidance for the first-time buyer interested in municipal bonds investing, including guidance on where to buy municipal bonds.
What are “municipal bonds”?
Municipal bonds are debt instruments issued by cities, states, and other governmental entities. In effect, when you buy a municipal bond, you are loaning money to the issuer, often in $5,000 chunks.
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The issuer, in turn, promises to pay you back, usually semi-annually, until the principal investment is returned on a specified maturity date. Investment horizons are either short-term, between 1 and 3 years, or long-term, between seven and ten years.
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Types of municipal bonds
There are three main types of municipal bonds, each carrying a varying amount of risk:
- General Obligation or G.O. bonds – These are bonds issued by states, cities, or counties to raise immediate capital, and they are backed up by the taxing power of the issuing body.
- Revenue Bonds – Revenue bonds are generally issued to fund major infrastructure projects – from schools and hospitals to bridges, road construction, and other major public projects. They are generally backed up by the income generated by the specific project.
- Conduit Bonds – These are revenue bonds issued on behalf of a private entity to fund a public purpose. The issuing body – whether the state, city, or county – is the “conduit” through which the bond is provided. It is the responsibility of the private entity to repay the bond to the provider for repayment to the funders.
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General advantages and disadvantages of investing in municipal bonds
Traditionally, municipal bonds have been seen as an attractive proposition for the risk-averse investor; there is little of the day-to-day volatility associated with corporate bonds or stock market speculation. But that is not to say there is no risk at all.
In the following section, we outline some of the headline considerations worth taking into account for anyone thinking about investing in municipal bonds.
Credit risk
Are municipal bonds a good investment? Like any debt obligation, the value of a municipal bond investment only holds if the issuer is able to make repayments.
According to Moody’s, municipal bond defaults have increased in number since the financial crisis, but relative to, say, corporate bonds, these remain infrequent, with an average of only 5 defaults per year between 2008 and 2013.
Although this is much higher than the average of 1.7 Moody recorded between 1970 and 2007, the number is still extremely low.
As with any other kind of investment, anyone considering municipal bonds investing should do their research. Any bond issuer has to provide details of their ability to meet interest and principal payments and their general financial condition via “official statements” or “offering circulars,” similar to the prospectus provided for corporate offerings. These records are accessible via the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access (EMMA) portal at MSRB.
An additional safeguard would be to check the issuer’s credit rating. Rating agencies such as Moody’s, Standard & Poor’s, and Fitch all provide municipal bond ratings, as do many banks and brokerage firms, and this is a useful method of attaining a professional evaluation of an issuer’s ability to repay the bond’s face value on maturation.
It pays to be cautious
A note of caution for anyone investing in municipal bonds: while credit ratings are important, and any missing information or late disclosure should be investigated more fully, the Financial Industry Regulatory Authority (FINRA) suggests that a higher credit rating should not in itself remove all cause for concern, not least because an issuer’s financial situation may change over time.
And credit ratings, while reflective of the rating agency’s evaluation of an issuer’s ability to repay, do not guarantee the stability of the bond’s market value and in some cases may also be reflective of certain protection features, such as bond insurance, rather than a bond’s intrinsic value and the financial health of the issuer.
Finally, a high credit rating does not, in itself, mean you will be able to offload or recover an investment when you want to or need to, especially if you are attempting to sell municipal bonds before their maturity date. This leads to other important considerations for anyone considering municipal bonds in 2017: interest rates and market risks.
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Interest rates and market risks
When municipal bonds are issued, the interest rate, or “coupon” rate, which doesn’t change over the lifetime of the bond, is usually based on the current federal fund rate. This means that changes to that rate can cause the value of the bonds to increase or decrease.
One of the major considerations for anyone investing in municipal bonds, therefore, is the effect of interest rate adjustments on bond prices. This is especially pertinent if a bond is sold before it matures. As an example, a municipal bond issued with a 5% coupon will be worth than more than newly-issued bonds if interest rates have fallen.
Conversely, a bond will be worth less relative to newly-issued bonds if interest rates have increased, and investors attempting to sell municipal bonds before maturity may find that they do not receive the full “par” value.
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How and where to buy municipal bonds
The Municipal Securities Rulemaking Board (MSRB) provides guidance on how to buy municipal bonds. They outline four main methods:
- Use the services of a broker or dealer to buy or sell municipal bonds
- Hire an investment manager who can locate and trade munis on your behalf
- Engage in direct trading through a self-managed online account
- Buy and sell shares in a municipal bond mutual fund or exchange traded fund (ETF)
Each method has its advantages and disadvantages. It is important that you choose the method that fits best with your investment strategy. For example, a broker or dealer is likely to charge commission; if you intend on making lots of trades, it might not be wise to opt for a per-transaction charging structure.
How to buy municipal bonds via a broker or dealer
For investors who are planning to sign up for the full term of a bond and are seeking the return of their principal, a broker or dealer in a dedicated bank department might be a good fit. Not only will brokers and dealers know how and where to buy municipal bonds, they will also have well-established legal responsibilities to investors and are more likely to have access to a full range of expertise to provide the most up-to-date and accurate information on municipal bonds investing.
That said, the final responsibility for any decision to buy or sell municipal bonds rests on the shoulders of the investor and, as always, caution is recommended.
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Registered Investment Advisor
A Registered Investment Advisor (RIA) is an option for those who would like to delegate responsibility for individual muni bond trades. RIAs have a “fiduciary” duty to investors, meaning that RIAs should always put your interests first when advising you and managing your account. RIAs generally charge a fee, either a fixed rate or a percentage proportion of a managed portfolio. The Security and Exchange Commission provides further guidance on how fees and expenses might affect your investments.
Direct trading
For some, direct online trading might be the preferred route for municipal bonds investing. This is an account held with a broker or dealer. This requires more engagement from individual investors, particularly as disclosure about a particular bond might be electronic only, rather than a discussion with a dedicated investment professional.
A self-managed account, while allowing greater investment autonomy, is still held with a broker-dealer and, as such, will generally charge the same commissions, mark-ups, and mark-downs as a regular brokerage account held with a broker-dealer.
Mutual funds and Municipal Bond Exchange Traded Funds (ETF)
Generally, this “portfolio” method of municipal bonds investing provides a naturally diversified portfolio at a lower cost than if each bond were purchased separately.
Mutual funds employ salespersons to aid investors in buying and selling their shares. The managers of mutual funds work to ensure a stable or increasing sale price. As such, if the interest rate rises, causing the value of certain bonds within the portfolio to fall, some of those bonds will be sold at a loss. This is an important consideration for those investors who intend to hold municipal bonds for the full duration of their term.
Municipal bond Exchange Traded Funds are mutual funds that are traded on the stock exchange, usually designed to track a specific index. Because these funds trade like a stock – though mutual funds can only be bought or sold once per day – the share price of municipal bond ETFs can differ from the underlying Net Asset Value of the fund. This, says the MSRB, can introduce another layer of potential volatility into the price that does not exist with a municipal bond mutual fund.
Investing in municipal bonds: The outlook for the rest of the year
While there remain specific areas of concern requiring caution (with the debt crisis in Puerto Rico as a painful case in point), the muni-bond landscape, generally, is pretty tranquil. But are municipal bonds a good investment now? Should investors buy municipal bonds?
Municipal bonds, for the most part, are immune from the general day-to-day turbulence of the financial markets, and, for the right investor, continue to offer a decent, albeit conservative, investment proposition for the rest of the year.
But in answering the question, “Are municipal bonds a good investment?” it is important to note that general uncertainty exists around the potential for further Federal Reserve interest rate raises. As explained in the section above, higher interest rates can eat into the face value of bonds.
As things stand, however, interest rates remain low, with uncertainty generated by slow economic growth, and events like Britain’s exit from the Europe Union contributing to continued low rates.
In a statement in June, the Federal Open Market Committee said, “The committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”
In summary, the current low interest rates present favorable conditions for anyone considering investing in municipal bonds now. But as with any investment, there are always risks attached; with municipal bonds, these are credit risk and interest rate risk.
But for those still asking, “Are municipal bonds a good investment?” it is important to note that these risks can be minimized with proper research and choosing an investment most suited to your needs – and getting a full and detailed account of the bond issuer’s financial situation, including up-to-date credit ratings, is also a wise choice.
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