Too many investors look at municipal bonds — debt securities issued by a state, municipality or county to finance its capital expenditures — as a blanket investment. They tend to think that muni bonds defaults can snowball. While there may be some truth to this statement, it's also like saying Nike Inc. (NKE) could go bankrupt because the stock market is crashing. As we all know, Nike is one of the best-run companies on the planet, and it’s not going anywhere. (For more, see: The Basics of Municipal Bonds.)
The same rule applies to municipal bonds. For instance, an AAA-rated municipal bond issued by a thriving city like Austin, Texas, is going to be safer than municipal bond issued by a shrinking city like Charleston, W.Va. The first city offers affordable housing, plenty of jobs, a low crime rate and good schools, which attract more people. The latter is suffering due to declining demand for coal. Residents are leaving or planning to leave, looking elsewhere for better opportunities.
If you plan on investing in municipal bonds, you should approach it just like you approach investing in stocks. Hopefully this means you put a great deal of time into researching the stock you’re considering, which should include digging into SEC filings, including 10-Qs and 10-Ks. When investing in municipal bonds, in addition to using common sense — how the state, county, city or town is performing from an economic standpoint — check the bond issuer’s Official Statements, including credit ratings and financial statements. (For related reading, see: How Are Zero-Coupon Municipal Bonds Taxed?)
It’s also recommended that you consider general obligation bonds before revenue bonds. General obligation bonds rely on taxes, which can be raised. Revenue bonds are backed by revenues from projects or systems, which aren’t as reliable. (For more, see: Tax-Free Muni Bond ETFs.)
Interest Rates, Taxes and Risk
In order to avoid interest rate risk, you can hold a municipal bond to maturity — interest rates on the bond will remain fixed. If you sell the bond early, then you will either have a capital gain or a capital loss. Savvy investors will buy a municipal bond with an attractive interest rate and hold it to maturity.
The biggest advantage to buying a municipal bond is that most of them are tax-free on the federal level. Additionally, almost all local bonds are free of state taxes. In most cases, you must be a resident of the state, county, city or town that’s issuing the bond. (For related reading, see: Muni Bonds vs. Bond Funds: Better Together?)
Another appealing aspect of municipal bonds is their low default rate. In 2014, the default rate on municipal bonds was just 0.17%. On the negative side, this was the first increase since 2011. There has been a lot of chatter about high risk to municipal bonds, but once again, municipal bonds shouldn’t be seen as one broad investment. Each municipal bond should be looked at individually.
Regardless of whether you’re worried about risk to the municipal bond market or not, you should seek diversification. This can be expensive because most municipal bonds require a minimum investment of $5,000. So another diversification option is through a municipal bond fund or muni ETF. Since municipal bond funds have an average expense ratio of 0.98% and muni ETFs have an average expense ratio of 0.30%, you might want to consider the ETF flavor first. Muni ETFs also offer more transparency and liquidity. You can also hire an investment advisor, but be sure to read the fine print on how much they charge. (For more, see: Diversify With Municipal Bond ETFs.)
Safe and More Dangerous Munis
There are currently some states, counties, cities and towns that offer more safety than others. If you want to invest in municipal bonds, consider the following locations, if you're local to them. (Also, use these lists as entry points to your own research):
- Austin, Texas
- Virginia Beach, Va.
- Polk County, Iowa
- Des Moines, Iowa
- Oklahoma City, Okla.
- Williamson County, Texas
- San Francisco
- San Antonio, Texas
The following areas might present more danger: (For related reading, see: Finding a Discount on Your Next Bond Investment.)
- Jefferson County, Ala.
- Washington (state)
- Harrisburg, Pa.
- Las Vegas
- Stockton, Calif.
The Bottom Line
Risk in municipal bonds is probably higher now than in the past due to the taking on of too much debt by government entities, which was based on the assumption that local economies would continue to grow. That said, risk is still going to be extremely low for municipal bonds issued by states, counties, cities and towns that are thriving. For diversification, consider a muni ETF. If you want a fixed interest rate, hold a municipal bond to maturity. Most municipal bonds are tax-free on the federal and state levels. (For more, see: Vanguard to Launch Muni Bond ETF.)