The following is the third of a series of weekly articles in which Sheryl will provide overviews of investment options that offer alternatives to bank accounts. Last week's article covered dividend stocks. As with any investment that's not an insured deposit account, there are risks. Some may feel that these risks are worth it for the chance of higher yields. The focus of these articles will be on conservative investments that may appeal to some savers who want a chance of higher yields and minimal risk.
There’s nothing flashy about municipal bonds. In a nutshell, they are debt securities issued by states, cities, counties and other governmental entities to finance capital projects, like airports, schools and highways. There are roughly 44,000 issuers of municipal bonds and over 1 million different bonds trading with a face value of about $3.7 trillion, according to Mike Nicholas, CEO of the Bond Dealers of America.
Simply put, if you buy a muni bond you are lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or "principal." The date when the issuer repays the principal, the bond’s maturity date, may be years in the future. Short-term bonds mature in one to three years, while long-term bonds generally will not mature for more than a decade.
While muni bonds may be plain vanilla in a world of exotic investments, that’s not to say they aren’t worth a look-see. They have some advantages.
Nicholas highlights some of them, "Historically, municipal securities have had significantly lower rates of default than corporate and foreign government bonds," he says.
Additionally, for a century, the interest income on most muni bonds has not been taxable. The tax status of muni bonds allows states and municipalities to issue bonds to investors at much more affordable interest rates. Muni bonds benefit from the security of a broad tax base, or a defined revenue source. Nicholas explains that the cash flows to make interest payments on a "general obligation" municipal bond are collected through a state or municipality’s ability to tax. Tax revenue can come from a variety of sources, including sales and property taxes.
"Municipal bonds are ideal for a buy and hold investor looking for steady cash flow and extremely high likelihood of principal repayment," says Nicholas.
Because typically municipal bonds have had very low correlation to other assets classes, such as equities and Treasuries, they can be effective portfolio diversifiers, points out Stephanie Larosiliere, client portfolio manager for Invesco.
What you need to know
Like all investments, there are risks, downsides when you invest in muni bonds or muni bond funds.
"Just because a municipal bond is insured does not mean it is without risk. The price of an insured muni bond will still fluctuate with interest rates, as well as with the overall muni bond market. They also still carry credit risk. The insurance is only as good as the insurance company backing up the guarantee. Take a close look at the insuring institution, and check the underlying bond rating as well. The underlying bond rating is the rating of the bond on its own without the insurance factored in," advises Curtis Chambers, a certified financial planner with Chambers Financial Group.
Credit worthiness of the issuer is critical with municipal bond insurance being dramatically reduced in the aftermath of the financial crisis. "Because of this, most investors are probably best served by utilizing municipal bond funds offered by reputable fund companies," says Graig Stettner, a financial advisor with LPL Financial.
Municipal bonds are not ideal in a rising interest rate environment. An investor who invests prior to rates rising will lose out on yield they could have earned if they waited to invest at higher rates, says Nicholas.
Secondly, because bond prices move in the opposite direction of bond yields, investors will suffer market-to-market losses on their bonds in a rising rate environment. But, due to the extremely low default rate and steady interest payments, and because most investors hold their bonds to maturity, these losses are rarely realized, says Nicholas.
‘It always amazes me to hear family members and others proclaim surprise and shock when they open their statements and their ‘safe’ tax-exempt muni bond lost value during the preceding period. After buying a fixed rate bond, your fixed rate is compared every future day to the fixed rate available on the same bond. If the market rates go higher after you buy, your rate isn’t as attractive as it was when you bought it and therefore the value of your bond goes down," explains John Payne, a registered municipal advisor.
However, if you sell before final maturity, you are subject to the then value per the markets. For example, if you buy a 10-year bond for $100 and the coupon interest rate is 3% annually, and you sell it two years after purchasing, eight years before final maturity, and, most importantly, when the eight-year rate in the marketplace for that bond would be 5%, don’t expect to get $100 back. Your bond lost value because rates climbed and your 3% just isn’t enough to entice anybody else to buy your bond, so you will sell at a discount to make up for the difference, says Payne.
On the contrary, if rates go down, or simply as a matter of time passing, your value will go up in a normal interest environment. "Buying with the intent of holding to final maturity is wise for retail buyers," says Payne.
All bonds are not created equal
Certain types of bonds are much more price volatile than others if sold prior to final maturity, such as zero coupon bonds, which are bonds sold at a large discount that don’t pay periodic interest. "Be sure you understand what you are getting if you intend to buy this type of bond. Bonds of this nature also include capital appreciation bonds (CABs), which are popular in many states," says Payne.
Know too, that not all muni bonds are exempt from tax, cautions Stettner. Usually interest received from bonds issued in other states is subject to state income tax, he says.
Periodic disclosure information, including financial reports and other material event notices are posted on a regulated website called EMMA, www.emma.msrb.org. You can look up your specific bond and locate periodic disclosures. This is useful to follow the general fiscal health of the municipality and become aware of any specific matters that may affect the value of your bond now or in the future. If credit conditions deteriorate, your bond may very well lose value, or worst case, may someday be subject to payment default, says Payne.
Investors should consider building a laddered structure of municipal bonds by utilizing target-date Exchange-traded funds (ETFs), which invest in bonds due in individual years. "This adds some certainty to one’s maturity structure vis-à-vis an open-end mutual fund," says Stettner.
Individual muni bonds or muni bond funds, as a rule, should not be held in a qualified retirement account. The interest loses its tax favorable status, says Michael Cice, registered principal with Allied Financial Consultants.
"Don’t forget Unit Investment Trusts (UITs) are also a good way to invest in municipal securities," adds Cice.
History is mostly favorable when it comes to municipal bonds. According to Jay Sommariva, vice president and senior portfolio manager of Fort Pitt Capital Group, "Throughout time, municipals have been a sound alternative in most fixed income portfolios with either institutional investors’ strategies or retail investors’ plans."