Municipal Bonds—Staying on the Safe Side of the Street in Rough Times

Municipal securities—often called "muni bonds"—are bonds issued by states, cities, counties and other governmental entities to raise money to build roads, schools and a host of other projects for the public good. FINRA and the Municipal Securities Rulemaking Board (MSRB) are issuing this Alert to remind investors that while munis have historically been considered relatively conservative investments, they do, like all bond investments, carry risk. As some state and local jurisdictions struggle with the fall-out from current economic conditions, investors should be aware that:

 

  • Defaults, while quite rare, do occur.

  • Information about financial problems that affect the bond’s issuer has not always been readily available to investors.

  • The current market value of a municipal bond may be hard to determine because many municipal bonds trade infrequently.

  • A bond’s market value may change for reasons having nothing to do with the financial condition of the issuer, such as a change in interest rates.

  • In cases where an issuer has purchased bond insurance or some other protection feature, the higher overall credit rating of a bond may be more reflective of that protection than of the financial condition of the issuer.

 

Investors considering an investment in municipal bonds should bear in mind that no two municipal bonds are created equal—and they should carefully evaluate each investment, being sure to obtain up-to-date information about both the bond and its issuer. This Alert describes the basics of municipal bonds, lists smart tips for considering a muni investment and provides links to helpful resources—including a new Investor Checklist, FINRA’s Smart Investing in Bonds and the MSRB’s EMMA Web site—to help investors avoid some of the most common pitfalls of municipal bond investing.

 

Muni Bond Basics


Municipal bonds generally pay a specified amount of interest (usually semiannually) and return the principal to you on a specific maturity date. One key reason many individual investors buy municipal bonds is the tax benefits: interest on the vast majority of municipal bonds is free of federal income tax, and if you live in the state or city issuing the bond, you may also be exempt from state or city taxes on your interest income.

 

There are two common types of municipal bonds:

 

  • General Obligation Bonds, referred to as GO bonds, are issued by states, cities or counties. They are backed by the “full faith and credit” of the government entity issuing the bonds. The creditworthiness of GO bonds is based primarily on the economic strength of the issuer's tax base.

  • Revenue Bonds are backed solely by fees or other revenue generated or collected by a facility, such as tolls from a bridge or road, or leasing fees. Bonds that are backed by a specific tax or assessment of a government entity, such as a tourist tax or other special tax or assessment, also are often considered to be revenue bonds. Unlike GO bonds, revenue bonds are not backed by the full faith and credit of the government entity issuing the bonds. Instead, the creditworthiness of revenue bonds depends on the financial success of the specific project they are issued to fund, on the revenues of a specific operational component of the government entity, or on the amounts raised by a specific tax or special assessment.

 

Historically, very few muni bonds have gone into default. But defaults can occur. Defaults tend to be higher for revenue bonds than for GO bonds—especially those that back private-use projects such as nursing homes, hospitals or toll roads.

 

Investors can buy and sell municipal bonds when they are initially issued or in the secondary market through the approximately 2,200 FINRA-registered firms and banks registered with the Securities and Exchange Commission as brokers or dealers in municipal securities. It is important to work with a broker and firm you trust. The firm and broker should have muni bond experience, and the broker should have the skills to conduct an analysis of the credit quality of the municipal investment.

 

Risk Factors

 

When it comes to evaluating a municipal bond, a major focus should be on the issuer’s ability to meet its financial obligations. A key question to ask is: How likely is the bond’s issuer to default? This is referred to as “default risk.”

 

One way to evaluate an issuer’s default risk is to assess its financial condition. When a muni bond issuer offers a new bond for sale, it usually discloses the details of the offering and information about its financial condition in the bond’s “official statement” (analogous to the prospectus used for corporate securities offerings). This information is typically updated each year—and also from time-to-time through “material events notices” concerning, for example, delinquency in principal and interest payments, other types of defaults, rating changes, events affecting the tax-exempt status of the bond, bond calls and other events.

 

These disclosures have historically been difficult and expensive for muni bond investors to obtain. Unlike publicly traded companies that issue stocks and bonds, muni bond issuers are generally exempt from registering their securities with the Securities and Exchange Commission and do not file ongoing disclosures, including audited financial statements, with any securities regulator. You may be able to get this information, for a fee, through one of the Nationally Recognized Municipal Securities Information Repositories (NRMSIRs).

 

The MSRB currently makes official statements and other muni bond disclosures available to the public for free through its Electronic Municipal Market Access (EMMA) Web site. Beginning on July 1, 2009, all ongoing disclosures submitted by issuers will become available to the public for free through EMMA, along with real-time trade pricing and up-to-date interest rate information on variable rate and auction rate securities.

 

Investor Tip: Ask Your Broker About Disclosure—Under SEC and MSRB rules,1 the brokerage firms and banks that sell muni bonds are required to have procedures in place to obtain material event notices and other disclosure. Ask your broker if a bond’s issuer is up to date with its reporting of its annual financial/operating data. Treat missing or past due financial information as a potential red flag.

 

Credit ratings can also help you evaluate a bond’s default risk. However, it is important to realize that these ratings are estimates only and should be only one of many factors in evaluating a municipal bond investment. Because ratings can change at any time, do not assume the rating shown on the official statement when the bond was first issued remains in effect if you buy the bond at a later date. Be sure to ask your broker for the current published ratings on any bond you are considering (and any bonds in your portfolio).

 

A high credit rating is not a seal of approval and neither reflects nor guarantees stability of market value or liquidity. In other words, a high rating does not mean that you will be able to sell an investment when you want or need to—particularly if you sell before the bond matures—or that you’ll get the price you expected.

 

That said, a low credit rating may very well be a sign of a bond’s increased risk of default or an indicator of greater liquidity risk and price level risk. As such, a low credit rating should not be taken lightly. So-called “high yield” munis often have low credit ratings—the higher return is meant to compensate investors for the higher level of risk they incur.

 

Bond Insurance and Credit Ratings: Some muni bond issuers include a repayment protection feature—most often bond insurance—to insure their bonds at the time they are issued. A bond with insurance generally is able to come to market with a higher credit rating, making the bond more attractive to buyers, and at the same time lowering the issuing cost to the municipality. The protection can shield an investor from default risk to the extent that the protection provider promises to buy the bonds back or to take over payments of interest and principal if the issuer defaults.

However, any guarantees are only as sound as the protection agent/insurance company that makes them. For this reason, when considering an insured bond, be sure to take into account the credit rating and long-term viability of the bond insurer. Following recent economic turmoil, the credit ratings of most bond insurers have been downgraded—and, in many cases, the current credit profile of the municipal bond issuer itself may now be higher than the current credit rating of the bond insurer.


Not all bonds have credit ratings. While an absence of a credit rating is not, by itself, a determinant of low credit quality, investors in non-rated bonds should be prepared to make their own independent credit analysis of the bonds. If you are unable to do so, ask yourself if the assumption of greater risk is worth the higher yield these bonds may carry.

 

Interest Rate Risk. Muni bonds are also subject to interest rate risk, which is the risk that an increase in interest rates may reduce the market value of a bond you hold. Interest rate risk—also referred to as market risk—increases the longer you hold a bond. This is especially true if you purchase a bond when interest rates are at or near historically low rates, as they have been recently. Rising interest rates generally make new bonds more attractive because they earn a higher rate of return. Interest rate risk and other risk factors are described more fully in FINRA’s Smart Bond Investing.


Smart Tips

 

Your overall investment strategy should be based on a number of factors, including how much risk you are willing to take, the purpose of your investment (income, growth or some of both), your investment horizon (when do think you will need the money) and whether it’s a good fit with other investments in your portfolio. These smart tips can help muni investors protect themselves:

 

  • Check out the broker and firm. A securities salesperson must be properly licensed, and his or her firm must be registered with the MSRB and with FINRA, the SEC or a state securities regulator—depending on the type of business the firm conducts. For a broker, use FINRA BrokerCheck or call toll-free (800) 289-9999. For an investment adviser, use the SEC's Investment Adviser Public Disclosure Web site. To confirm MSRB registration, contact MSRB.

  • Don’t reach for yield. Never make your investment decision based solely on a bond’s yield unless you are willing to assume more risk. The higher return you are “reaching for” is an indicator of increased risk.

  • Read the Official Statement. Ask your broker for information about the municipal security before you purchase it. The bond’s Official Statement is where you will find a bond’s important characteristics, from yield to the bond’s call schedule. Be aware that an Official Statement may not be prepared for offerings under $1 million and certain offerings sold primarily to institutional investors.

  • Keep up with material news, including updated financial information and material event notices. An issuer’s circumstances may change over time. Stay abreast of changes to underlying economic factors, a bond’s credit worthiness, and the issuer’s financial capacity. Ask your broker how current the issuer is with its disclosure—and be aware that an issuer’s failure to furnish current information about its financial situation is a potential red flag. Beginning on July 1, 2009, you will be able to access on-going disclosure filings for free using EMMA.

  • Evaluate a bond’s price. Bonds are generally issued in multiples of $5,000, referred to as a bond’s face or par value. But they can trade above or below par in the secondary market for many reasons, including changes in current interest rates or the real or perceived credit quality of the issuer. Use FINRA’s Market Data Center or MSRB’s EMMA to check a bond’s trading history, including how actively the bond trades (many trade infrequently) and recent pricing. If the issuer has filed a distress notice but has bonds trading at or above par, ask why.

  • Do your homework. Before buying any municipal bond, carefully consider the financial condition of the state, city or county that is issuing the bond and any other party that is responsible for payment on the bond. For revenue bonds, ask whether the issuer’s revenue has been enough to cover the payments it must make on the bond (also known as the “debt service ratio”). With all munis, ask your broker about the bond’s call schedule and see if the bond’s credit rating has gone up, down or remained stable.

  • Do the tax math. Run the numbers (or ask your broker or tax advisor) to determine whether buying a tax-free muni bond, particularly in your home state, makes sense for you. For more information and a formula to help you compare yields, see Muni Math in FINRA’s Smart Bond Investing.

  • Diversify. Market risks can be mitigated to a certain extent by diversification among different asset classes and within the same asset class. When diversifying within the muni bond asset class, consider diversification by issuer, location and maturity date. One way to diversify your muni bond holdings is to invest in a muni bond mutual fund or muni ETF. Be sure to research the securities contained in a given fund or ETF, as well as maturity lengths (longer maturities usually mean greater risk). Be aware that bond funds and ETFs may invest in a narrow group of holdings (only tax-deferred bonds, for instance) and so your diversification may be limited. Bond funds and ETFs can decline in value, and prices fluctuate, making it impossible to know the value of your holdings prior to sale.

 

Additional Resources

 

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1 MSRB rules are enforced by FINRA for securities firms, bank regulatory agencies for bank dealers, and the SEC for all brokers, dealers and municipal securities dealers.

Last Updated: 6/30/2009