The muni bond exodus
Historically, municipal bonds have not generated national headlines, but the fiscal problems facing many state and local governments have led to newsworthy concerns about the future of these securities. As a result, by February 2011, investors had pulled nearly $40 billion from municipal bond funds—the largest exodus from such funds in decades, according to the Investment Company Institute.But were investors exiting an investment class that truly had taken a turn for the worse?
Before you decide whether municipal bonds still have a place in your own portfolio, it’s worth taking a closer look at the asset class: specifically, how the features of municipal bonds and whether their benefits—such as the potential for tax-exempt income—merit consideration in the current environment. These investments can still play a role in a long-term investment strategy, as long as the risks associated with the bonds you own are aligned with your own risk tolerance.
Municipal bonds are debt obligations issued by cities, counties, states and other government entities. Often called “muni bonds,” they are used to fund projects that are considered by the municipality to be beneficial to the public good.
In exchange for funding public projects and services, investors in municipal bonds receive a benefit: The interest paid on municipal bonds is generally exempt from federal income taxes. Moreover, interest paid to investors who purchase a bond issued by a municipal entity located within their home state is typically exempt from state income tax, and interest paid on some bonds (called triple-tax-free bonds) is even exempt from local taxes.
Behind the Headlines
Should you choose to access the municipal market, it is important for you to know what you own, and ensure that what you own is in line with your tolerance for risk. Just as important: understanding that the municipal bond market is extremely broad and diverse, frequently defying broad generalizations.
For example, some municipal issuers may be strapped for cash while others are in good financial health. While a project funded by one bond issue may fail to generate sufficient revenues, leaving it unable to pay interest on its debt, another project funded by a different bond issue in the same city may have no difficulty generating abundant revenues.
Furthermore, the municipal market has changed dramatically in the past few years, due to a significant decrease in the use of insurance by municipal issuers (following the credit crisis of 2008/2009) and a growing presence of ‘non-traditional’ municipal bonds. You should be aware that all muni bonds are not created equal. Be sure that you understand all of the material terms and features of any municipal bond before you invest, including the issuer/obligor of the bond, sources of revenue, and creditworthiness of the entity backing the bond.
Know Your Investments
Now more than ever, you need to understand a municipal bond’s credit quality and the process by which it generates income. Most issuers are graded by credit rating agencies such as Moody’s, Standard & Poor’s and Fitch Ratings. Each agency has a different grading system, but AAA is typically the highest rating. Lower ratings indicate that the rating agency has assessed that there is incrementally greater risk of potential default. As a result, investors can begin the process of assessing municipal bonds by filtering out bonds with ratings they deem too risky.
You should be aware that insured bonds are typically assigned the higher of either the issuer’s or the insurer’s credit rating. In the case of an insured bond, be sure to review the rating of the issuer, which may be lower. Also keep in mind that you should not rely solely on ratings, as they are only one of several factors to consider when evaluating an investment.
Rather than shunning this asset class altogether, investors who can benefit from tax-exempt income should work with their Financial Advisor to determine whether certain specific municipal bonds or bond funds may be suitable for them and, if so, take a closer look at these bonds or funds as a potential investment.