Investing and investment markets are not the forte of many hard-working Americans, let alone understanding the various investment vehicles and their intricacies. Hence, many investors turn to their financial advisors and other finance professionals for guidance and earn enough to live comfortably in their golden years.
There are many common perceptions regarding the investment markets that dictate an investor’s decision making, or their acceptance of the recommendations of their investment manager. Some of these commonly held beliefs include:
- stocks are risky, bonds are safe;
- fixed-income instruments mean that your investment will generate fixed income until maturity;
- municipal bonds are backed by the taxing power of the municipality;
- municipal bonds are tax free; and
- corporate bonds are riskier than municipal debt.
Although some of these perceptions or beliefs may hold some truth, there is always a bigger picture, and many debt and equity instruments are far more intricate than what we might initially think of them.
In this article, we’ll take a closer look at the right and wrong reasons to invest in municipal bonds and shed more light on these commonly held beliefs.
Why Do Investors Invest in Municipal Bonds?
Bonds and other fixed-income investment instruments have been relatively attractive to conservative investors who seek safe investments with a stream of income. Many investors try to assume an added layer of protection with municipal debt over corporate bonds, simply because they are issued by a local government rather than a corporation.
Let’s take a closer look at the commonly held beliefs around munis, as well as what the bigger picture looks like.
Muni bonds are safe and risk-free investment vehicles: The consensus amongst many fixed-income investors is to favor municipal debt over any form of corporate debt, due to the local-government backing and the taxing authority of these entities to meet their debt obligations. This belief was met with a rude awakening during the 2008 financial crisis in the U.S., where some of the biggest municipalities filed for bankruptcy. The looming concern of municipal defaults is progressively increasing due to various reasons. For instance, historic droughts in California have led local governments to employ extreme water conservation measures that have impacted water revenues and the ability of the local governments to meet bond covenants. Furthermore, several municipalities have been facing growing pension liabilities due to considerably low returns on their pension portfolios and increasing healthcare costs for retirees.
The value of fixed-income instruments is inversely tied with interest rates; this means that in a rising rate environment, the value of your bond portfolio will decrease. In recent times, there has been upward pressure on interest rates by the federal government. As interest rates continue to move upwards, investors will need to consider restructuring their long-term debt portfolios.
Muni bonds offer a tax-free investment opportunity: Due to the tax benefit, muni returns are always higher than their corporate counterparts; however, when comparing the tax-free income to the tax-equivalent yield, the corporate bond may still come out ahead with similar rating and maturities. In addition, given the interest rate environment, investors may be paying huge premiums on their purchases, which means the stated coupon of a bond will be worth less. For example: an investor buys a municipal bond with $1000 face value bond with a 5% coupon for $1050. Considering the management fees and the rate environment at maturity, the total value of coupon payments can be far less than what was originally assumed.
Keep our glossary of municipal bond terminologies handy to familiarize with different concepts commonly used by municipal investors.
Muni bond investment is cheap: The other commonly held belief is the ease of buying and selling municipal securities; however, the illiquid nature of municipal markets can be quite costly to transact in these instruments. This means bigger spreads that will potentially eat into coupon returns, in addition to the brokerage fees.
Muni bonds are easy to comprehend: Municipal debt is comprised of a wide array of debt instruments that can be structured very differently from one another. Investors often overlook and do not understand the complexities of bond ratings and how different debt issues are backed by different types of revenues. For example, in the event of general fund bankruptcy of a municipality, the general fund–backed debt takes the hit and the revenue-backed debt or enterprise debt is generally not impacted.
Muni bonds offer a simple and easy way to diversify one’s portfolio: Although municipal bonds are known to offer portfolio diversification benefits, it is true only when prudent asset allocation strategies are adopted and rebalanced based on the market scenario. In general, portfolios that are predominantly comprised of fixed-income instruments are likely to have a bigger opportunity cost to earn potentially better returns than on more diversified portfolios. A diversified portfolio will not only provide safety in a dynamic interest rate environment, but proper exposure to equities can also enhance overall portfolio returns.
Be sure to check this article to remain aware of the due diligence process for evaluating municipal bonds.
Regulatory Regime in U.S. Can Dictate Municipal Debt Investment Choices
Often, a political shift brings a slew of new policies and initiatives. For instance, the Trump administration has strongly hinted towards bringing significant changes to the current healthcare system, tax reforms and the U.S. infrastructure ecosystem. The President and his team have put plenty of emphasis on PPPs (public-private partnerships) to revamp infrastructure setups like airports, bridges and highways. These initiatives will have a huge impact on the municipal markets because these are often funded by tax-exempt municipal debt. In addition, for healthcare debt issuers and investors, the potential changes to the Affordable Care Act can cause worryfor the future.
As a result, it is always advisable to avoid investing in muni bonds issued for controversial projects or from issuers currently undergoing substantial financial troubles.
Check out how Trump’s policies could impact the municipal bond ecosystem.
Check out the different ways to invest in muni bonds to stay up to date with the current investment strategies.
The Bottom Line
For risk-averse investors, the municipal debt sector has been a good safe haven mainly due to the market and political uncertainties and the perception of safety. The illiquidity of the municipal debt market, along with higher spreads, uncertainty around regulations within various municipal sectors and a rising interest rate environment, may shift the interest of these investors to other fixed-income instruments or even to other asset classes.
Investors should keep a close eye on the credit ratings as they relate to certain issues, municipal issuers and different sectors, as they can shed a light on current and near-future financial health. Furthermore, almost all municipal issuers conduct various surveillance calls with their respective ratings agencies, and those surveillance reports can be quite informative in understanding the financial conditions of a municipality.
In the end, if an investor can find better opportunities, he or she should consider giving municipal bonds a pass.
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