As a holistic financial planner, I’m often approached by my clients asking about the value of investing in bonds, including municipal bonds. Given that Moody’s recently assigned an Aaa rating to Naperville, IL's General Obligation (GO) Bonds (continuing a twenty year streak of Aaa ratings for our fair city), you may be wondering if municipal bonds are a worthy investment for your family.
Aaa rated issuers and Aaa bonds have a relatively low risk of default which can make them look like an attractive investment for risk-averse investors. However, municipal bonds are not as “safe” as generally believed to be, and aren’t an effective investment for everyone. There are a variety of factors you should examine to determine if this type of investment is the best strategy to help you meet your financial goals.
What is a municipal bond?
Municipal bonds, also known as muni bonds or munis, are bonds that are issued by a city, state, cities, county or other government entity to help fund public projects or municipal government operations. When you purchase a municipal bond, you are essentially lending money to the bond issuer in exchange for a promise of regular interest payments plus the return of your original investment, otherwise known as the principal. Municipal bonds can be short term (maturing in 1 to 3 years) or long-term (maturing in 10+ years).
Municipal bonds are tax friendly and perceived as a relatively safe investment. Because of this, people may wonder if municipal bonds are a savvy vehicle for diversifying their portfolio, or a means to reinvest their portfolio during times of economic uncertainty.
Types of municipal bonds
The two most common types of municipal bonds are revenue bonds and general obligation bonds.
Revenue Municipal Bonds:
- are paid using fees and other income-generating sources
- return cash flows generated from the project itself
- examples include toll roads, public pools, hospitals, higher education etc.
General Obligation (GO) Municipal Bonds:
- are backed by the issuer's ability to raise capital through levying taxes
- provide cash flow generated from taxes collected on a project
- some are backed by dedicated property taxes; others from general funds
- examples include state income taxes and local school districts dependent on property taxes
Essentially, a GO Bond’s creditworthiness boils down to two factors: the municipality’s ability to pay and its ability to pay on time. Many investors are under the impression that municipal bonds have very little risk. After all, historic municipal bond default rates were only about 0.5% during the Great Depression, making them especially attractive to risk-averse investors. Plus, municipal bonds are often exempt from federal taxes and sometimes state and local taxes, making them an appealing option for high earners who want to hold on to capital while still creating a tax-free financial source.
Are Municipal Bonds a good way to invest your portfolio?
I often find that bonds are some of the simplest but most misunderstood assets. Although purchasing municipal bonds is comparatively low-risk than other types of investments, they are not entirely without risk. As a financial advisor, I am not a proponent of investing in individual equities like Municipal GO Bonds - there's just too much unnecessary risk. While municipal bonds are good for people who want to preserve capital while generating interest, I prefer equities bonds issued by companies that trade on an exchange (also known as stocks or shares) or bonds with shorter durations to minimize fluctuating interest rate risk.
Here is a rundown of reasons why I find municipal bonds like GO bonds to be unappealing as a means to safely grow your portfolio:
1. Credit Risk
The bond issuer may experience financial problems that make it difficult or impossible for them to pay back your interest and principal in full. If the financial stability of the issuer deteriorates, the ratings may slip and the value of the bond diminishes. This is why if you are planning to invest in municipal bonds, it is critical that they are rated highly by investor service organizations like Moody’s and Standard and Poor's (S&P), as is the case with Naperville GO Bonds.
2. Fluctuating Interest Rates
Because it is a fixed-income security, the market price of a municipal bond fluctuates with changes in interest rates - meaning when interest rates rise, bond prices decline; and when interest rates decline, bond prices rise. If interest rates rise, bond-holders can lose money if they try to sell the bond before it matures.
3. Duration Risk
Likewise, a municipal bond with a longer maturity period is more vulnerable to interest rate changes than a bond with a shorter maturity period.
4. Liquidity of the Bond
Because they are meant to be held until maturity, the majority of municipal bonds are illiquid. If investors can’t find an active market for the bond, an investor needing immediate cash may have to sell other collateral instead.
5. Transaction Costs
When every penny counts, it is important to know that individual bonds are associated with higher transaction costs, while bond funds (funds that invest in bonds or other debt securities) have very low transaction costs.
While Naperville’s Aaa rating on its GO bonds make them look like a safe investment, it’s best to consider all the factors that affect their financial benefits before buying.