CHICAGO — When it comes to investing your money, there’s more than enough pessimism to go around, and nowhere is it easier to find than in today’s municipal bond market. Many state and local municipalities are facing the toughest budget problems they have ever seen. California, Illinois and New Jersey are among the states wrestling with money woes. Major cities such as Philadelphia, Atlanta, and Columbus, Ohio, are on a long list of municipalities looking at major tax increases and/or cutting of services and personnel as a last resort for rising above an enveloping debt crisis.
Marilyn Cohen, president and CEO of Envision Capital Management, describes the current bond market as “the biggest slow-motion train wreck I've ever seen.”
Still, despite all the pessimism, defaults, though they can and do happen, continue to be exceedingly rare. John Miller, who is in charge of Nuveen’s municipal bond department, is among many financial experts who feel that the pessimism may be overdone. Quoted in Kiplinger’s Personal Finance Magazine, he said, “There is a distinct difference between what the fiscal balance of a municipal government looks like versus the municipality’s ability to service and repay its debts on time.”
Whether or not you are among the many savers and investors who still find the tax-free status of municipals to be worth whatever risk may be involved, there are important details worth knowing about this form of investment.
There are two classes of municipal bonds — general obligation bonds and revenue bonds. The significant difference between the two is the type of collateral used to secure the payments of interest and the repayment of principal at maturity.
General obligation bonds (GO) are regarded as the safest of the two. They are backed by the full faith, credit and taxing power of the issuing municipality. In short, this means that the issuer commits its full resources to paying its obligations to bondholders, including the raising of taxes if necessary. In general, GO bonds give municipalities a means for raising funds for projects that do not generate revenue on their own the way that toll roads and bridges do. The ability to raise taxes, if needed, gives GO bondholders an extra level of assurance against default. For example, a town may create a GO bond issue to finance the building of a new school. Buyers know that the issuer will have the ability to raise taxes to pay its bond obligations if that becomes necessary.
As a result of this low-risk status, GO bonds will typically pay somewhat lower returns than revenue bonds.
Municipal revenue bonds are financed in a completely different manner. They are distinguished by their guarantee of repayment solely from money generated by a specified revenue-generating entity such as a toll road or a bridge. Only those revenues specified in the contract between the bond buyer and bond issuer are required to be used for repayment of the principal and interest of the bonds. Because the pledge of security is not as great as that of GO bonds, revenue bonds will usually offer a slightly higher interest rate than GO bonds.
If your primary investing objective is to preserve your capital while generating a tax-free income stream, municipal bonds are still worth considering. Despite the concerns brought about by our struggling economy, defaults on municipal bonds of either type continue to be rare.
However, potential municipal bond investors need to be aware of a significant change in the bond marketplace since the financial crisis of 2007-2008. Prior to that time, well over half of all tax-free bond issues were guaranteed by independent insurance companies. Today, less than 10% of new issues are insured. Because of that, triple-A rated bonds have become harder to find.
All of these apparent negatives have resulted in a “nervous” municipal bond market of late, especially in view of the recent debt-ceiling crisis and downgrading of Federal bond issues. However, one clear possibility now looming would be a rise in income-tax rates at both state and federal levels. If that happens, tax-free municipals will become far more attractive. If the Bush tax cuts are allowed to expire, the top federal tax bracket will climb to 39.6%. In that case, a 3% tax-free yield would be equivalent to a taxable yield of about 5%.
If you decide to take advantage of tax-free municipals, you have an important decision to make. Picking your own individual bonds to purchase from a broker is now a more complex task than ever. That’s why I favor the mutual fund approach. By buying a mutual fund that holds only tax-free municipals, you automatically gain the advantage of broad diversification and thus lower risk from a single default.
Arguably, an even better approach would be turning to the relatively new Exchange-traded funds (ETFs). Municipal ETFs offer the same broad diversification as mutual funds with the added advantage of lower costs. Typical management fees for ETFs range from 0.25% to about 0.35%, much lower than those charged by regular mutual funds. ETFs are also easy trade on the open market.
If you decide to go it alone by selecting and buying individual bonds, it’s important not to cede control to your broker. Don’t buy a specific bond recommended by your broker simply because it will pay him or her a generous commission. Do your homework. That part of the job is up to you.
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax adviser for advice regarding your particular situation.