Investing in bonds is one part of a balanced and diversified portfolio. Even the most aggressive investors are advised to keep a small percentage of their portfolio in bonds as a way of minimizing systematic risk. Bonds offer the benefit of predictable income at the expense of the chance for growth that beats the market. However, like stocks, there are a variety of bonds for investors to choose from.
One of these types and the focus of this article is the municipal bond. In this article, we'll dive into the details of municipal bonds which feature tax benefits that may be appealing to income investors.
What are municipal bonds?
Municipal bonds (otherwise known as “Munis”) are government-issued debt securities that are used to fund day-to-day operating expenses or to fund large-scale capital projects like building schools and repairing highways and bridges. When an investor purchases a municipal bond they are essentially loaning money to the government in exchange for a series of interest payments to be paid on a regular schedule and a return of their original investment once the term of the bond expires. Bonds can be short-term, which are typically one to three years or long-term, which can have maturities of over 10 years.
There are two types of commonly issued municipal bonds. The first is what is called a general obligation bond and the second is a revenue bond.
- A general obligation bond is an unsecured bond that is issued by a state, city, or county. By unsecured, it means they are not backed by hard assets, rather they are backed by the “full faith and credit” of the bond issuer. This means that the government that issues the bond can tax residents of that state, county, or municipality to raise the revenue to pay back the bondholders.
- A revenue bond is backed by the revenue that will be created by the specific project. Toll roads and lease fees are two common types of revenue streams that would be used to pay bondholders. However, there is a somewhat higher risk to investors because many revenue bonds are "non-recourse" bonds which mean that if the revenue source were to dry up so would the funding source, leaving bondholders with "no recourse" to claim their interest payments or principal.
A variation on these bonds is a when a government entity issues a bond on behalf of a third party such as a hospital or non-profit university. In this case, the third party (known as the "conduit" borrower) repays the issuer of the bond who in turn pays the interest and principal to the bondholders. Like a revenue bond, however, there is a risk of default if the conduit borrower is not able to make payments to the issuing party. This is because, in most cases, the issuer is not required to repay the bondholders.
Tax benefits of municipal bonds
One of the benefits of municipal bonds is that the interest that investors receive from the bonds is not taxed at the federal level. In many cases, bondholders are exempt from state or local taxes if they reside in the state or municipality where the bond is being issued. However, because of the tax benefits investors receive, they often accept a lower interest rate in return.
How interest rates affect municipal bond prices
Interest rates affect municipal bond prices in the same way that they affect other bonds. That is that rising interest rates work in favor of the bond issuer and declining interest rates work in favor of the bondholder. Let’s look at an example of how this might work with a $1,000 bond issued by Anywhere, U.S.A.
When the bond is issued, interest rates are at 2.5%. The par value of the bond is the same as its market value, which is $1,000.
If interest rates increase:
An investor wishing to purchase that $1,000 bond will have to pay a premium (i.e. a price higher than the bond’s par value). However, at maturity, they will only receive $1,000.
If interest rates decline:
An investor wishing to purchase that $1,000 bond will be able to buy it at a discount to its par value, yet still, receive $1,000 at maturity. This makes the bonds more desirable to purchase.
What are the risks involved with municipal bonds?
Government entities are not for profit operations. That means unlike a corporate bond that allows investors to evaluate a company’s balance sheet for clues to their ability to pay bond obligations, no such structure really exists for municipalities. If tax revenues decline, the issuer may not have the necessary funds to compensate the bondholder. While municipal bonds have credit ratings, just like other bonds, a high rating does not mean that the bondholder will not default. However, it is fair to say this risk is not necessarily greater or worse than the risk presented by corporate bonds.
Aside from that default risk, however, there are other subtle risks to owning municipal bonds.
- Call Risk – It is possible for the bond issuer to "call" a bond which means repay the buyer their principal and all unpaid interest prior to the maturity date. This is typically done when interest rates are falling. The bond issuer, in this case, the government, is seeking to take advantage of lower long-term borrowing costs through lower interest rates. This would be similar to a homeowner who refinances their mortgage to take advantage of lower interest rates. Of course, when interest rates are stable or projected to move higher the call risk associated with these bonds is negligible.
- Interest Rate Risk – Municipal bonds carry a fixed-rate value (referred to as its “par” value). When the bond reaches maturity, the bondholder will be paid the par value plus any interest. However, a bond’s market value will continue to move up and down with prevailing interest rates which can mean that the market value will be lower than the par value. Bond prices and interest rates move in opposite directions. When interest rates fall, the market price of a bond will rise and when interest rates rise, the market price of a bond will fall. So if a bondholder is holding a bond with a low fixed-rate value and interest rates move higher, they may lose money should they try to sell the bond before maturity could lose money because of its lower market value.
- Inflation Risk – The risk here is similar to the interest rate risk since inflation generally results in higher interest rates, which lowers the market value of a bond. However, another risk with inflation is that the purchasing power of the interest they receive will now be reduced as inflation raises consumer prices.
- Liquidity Risk – Many bondholders buy municipal bonds to hold them rather than to trade them. But this means that investors who may be inclined to sell a municipal bond may find the market for selling is not very active, which could result in an inability to sell the bond when they would like or an inability to sell the bond for the price they desire.
Common terms related to bonds
Bonds of all types have a common language. Here are some common terms investors should be familiar with as they relate to municipal bonds.
- Face value (also called par value)– This is the amount of money the bond will be worth at maturity. The face value also sets the value that establishes the base for interest payments (or coupon payments).
- Coupon rate– This is the interest rate the bond issuer pays to the bondholder. The coupon rate is based on the face value of the bond and expressed as a percentage. If interest rates rise before the bond matures, the coupon rate remains the same as when the bond is purchased. If a $1,000 bond is offering a 5% coupon rate, every bondholder will receive $50 coupon payments regardless of the price they paid for the bond.
- Coupon Dates – these dates let the bondholder know when the issuer will make their interest (or coupon) payments. These payments are usually made on an annual or semi-annual basis.
- Maturity Date – this is the date when the bond is said to mature and the issuer pays the owner of the bond the face value of the bond.
- Issue Price – this is the original market price the bond is sold for. If the bond sells above its face value, the “issue” is said to be selling at a premium. If the bond sells below its face value, the “issue” is said to be selling at a discount.
How is a bond’s interest rate determined?
The interest rate of a bond is set by two factors. The first is the credit rating of the bond issuer. This is similar to what consumers experience when they seek a bank loan. Just like a corporation, government entities have credit ratings. Those with a poor credit rating will have bonds that trade at a discount as prospective buyers assess the potential default risk with the price they pay for holding the bond. This should serve as a warning for investors that are tempted by the allure of a high yield. Bond investing is about security. A municipal bond is even more about security. If a municipal bond has a yield that seems too good to be true, it may indicate an underlying problem.
The other factor that determines the interest rate on a bond is the length of maturity. In general, the longer a bond issuer is asking you to hold the bond before maturity will dictate a higher interest rate as a reward. This, however, reflects normal market conditions with a yield curve that shows long-term rates being higher than short-term rates. In a case where the yield curve is flattening or inverting, investors may see higher interest rates on short-term bonds.
How can investors research municipal bonds?
Just because a municipal bond is not issued by a public company does not mean there are not resources available to investors to determine the quality of the bond, and therefore the potential default risk involved with the bond. A free source of information regarding municipal bonds can be found at the Electronic Municipal Market Access (EMMA) website from the Municipal Securities Rulemaking Board. You can find disclosure documents which are similar to a company’s prospectus. You can also view historical and real-time transaction price data. However, the availability of recent price information depends on how actively a particular bond issue is traded.
The final word on municipal bonds
Municipal bonds are considered to be one of the safest and least risky of all kinds of bonds. There are two basic types of municipal bonds. A general obligation bond is not secured by hard assets by virtually assures a bondholder of repayment because the government entity can use taxation as a means to gain revenue to repay their bondholder. A revenue bond is one that pays bondholders through the revenue stream gained by the project such as the tolls collected for a highway.
Municipal bonds do not tax the interest bondholders receive at the federal level and in many cases will not tax at a state or local level provided the bondholder resides in the state or municipality where the bond is issued. In return for this favorable tax treatment, however, bondholders typically receive a lower rate of return than they would receive with a corporate bond.
In general, the risks associated with a municipal bond are no different than with a corporate bond. The most common types of risk are default risk, call risk, interest rate risk, inflation risk, and liquidity risk.
As with any other investment, bond investors should do their due diligence before purchasing a municipal bond and avoid bonds that carry a yield that seems too good to be true. In many cases, that may point to larger underlying problems.