The bankruptcy filing of the city of Detroit has left some investors questioning their long-held assumption about the relative safety of municipal bonds.¹ Without question, in the wake of Detroit’s troubles, gaining a better understanding of municipal bonds makes more sense than ever.²
At their most basic level, there are two types of municipal bonds:
- General obligation bonds, which are a promise by the issuer to levy taxes sufficient to make full and timely payments to investors, and
- Revenue bonds, which are bonds whose interest and principal are backed by the revenues of the project that the bonds are funding.
Types of Risk
Both general obligation and revenue bonds share certain investment risks, including but not limited to market risk (the risk that prices will fluctuate), credit risk (the possibility that the issuer will not be able to make payments), liquidity risk (muni markets may be illiquid and result in depressed sales prices) and inflation risk (the risk that inflation may erode the purchasing power of bond’s and principal and interest payments). They also may share call risk, the risk that a bond may be redeemed prior to maturity.
Revenue bonds are consider riskier than general obligation bonds since they are obligated to make repayments only to the extent that the project funded by the bonds are able to generate the necessary level of revenues to meet these payment obligations.
Managing Risk
Investors seeking to manage their risk may want to consider investing in general obligation bonds with investment-grade ratings.
Bonds used to support essential services, such as water or sewage, are also considered less risky since these services are normally unaffected by economic conditions that may impact other revenue bonds, such as private activity muni’s, which fund projects by private businesses or nongovernmental borrowers.
In light of the widespread uncertainty about the fiscal health of municipalities nationwide, diversification may be more critical now than ever before.³
Since municipal bonds generally are sold in increments of $5,000 and may be subject to disadvantageous pricing for smaller investors, many individuals look to mutual funds to manage their municipal bond portfolio since they offer the diversification, research and analysis and buying power that most individuals can’t match.
Mutual funds are sold only by prospectus. Please consider the charges, risks, expenses and investment objectives carefully before investing. A prospectus containing this and other information about the investment company can be obtained from your financial professional. Read it carefully before you invest or send money.
- Reuters, August 15, 2013. A municipal bond issuer may be unable to make interest or principal payments, which may lead to the issuer defaulting on the bond. If this occurs, the municipal bond may have little or no value.
- Municipal bonds are free of federal income tax. Municipal bonds also may be free of state and local income taxes for investors who live in the area where the bond was issued. If a bondholder purchases share of a municipal bond fund that invests in bonds issued by other states, the bondholder may have to pay income taxes.It’s possible that the interest on certain municipal bond may be determined to be taxable after purchase.
- Diversification is an approach to help manage investment risk. It does not eliminate the risk of loss if municipal bond prices decline.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. Some of this material was developed and produced by FMG, LLC, to provide information on a topic that may be of interest. FMG, LLC, is not affiliated with the named broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Copyright 2014 Faulkner Media Group.
