An official with the Securities and ExchangeCommission -- an
agency not given to hyperbolic statements -- said this $3.7
trillionmarket is facing an "Armageddon."
In June alone, $5.4 billion flooded out of this market -- more
than was invested in all of 2012. Rising interest rateswill
likely depress the value of this market over the next few years.
Not only that, but President Barack Obama wants some investors in
this market to face an unprecedented penalty.
Why should you give it even a cursory glance?
In 2012, this market finished a two-year run with an average
20%gain , according to Bank of America Merrill Lynch. It is one
of the most trustworthy places toput yourmoney , especially if
you're a retiree.
I'm talking about U.S. municipal bonds.
Municipal bonds are issued by non-federal governmental
entities to build roads, schools, hospitals and the like. In
2012, 6,600 tax-exempt municipal bonds financed more than $179
billion worth of infrastructure projects, according to National
Association of Counties.
Nearly three-quarters of thesebonds are held by individual
investors, according to the SEC.
With about 50,000 localbond issuers across the country and
more than 1.5 million bonds outstanding, no two municipal bonds
are exactly alike. Yet right now they're all being tarred with
the same brush.
Here are three key reasons they're in the headlines.
||The Federal Reserve signaled that it
might begin easing off its bond purchases in a "tapering"
of its quantitative easing program later thisyear .
Afterthe Fed 's signal, investors dumped anything with the
word "bond" in it. That selling drove up theyield on
thebenchmark 10-year Treasury from 1.63% in early May to a
recent 2.74%. That, in turn, has pushed up long-term rates
on municipal bonds.
||The City of Detroit defaulted on two
bond payments before declaringbankruptcy this week.
Thedefaults were a pretty minor event for individual
investors because those specific bonds were insured. As for
the bankruptcy, Detroit will negotiaterepayment terms that
will delay repayment for some for the highest-rated bonds,
will hit the insurers, not the bond holders or the
Detroit's plan for getting its finances in order calls
forbondholders to shoulder some of the burden. The
possibility of that turn of events is what had SEC
Commissioner Dan Gallagher invoking the end of the world.
He was not saying that municipal bonds have become
badinvestments -- he was referring to the change in how
different bond classes are handled in restructurings could
make it more difficult and expensive (because of higher
insurance rates) for municipalities toissue bonds in the
And he was right. Hundreds of millions of plannedmunicipal
bond issues have been canceled or postponed.
||For the first time, the U.S. Treasury
said it wouldsupport the measure to tax higher-income
investors who hold tax-free bonds to help close the budget
Some Comforting Facts
As far as the individual investor is concerned, none of the
fundamentals of municipal bondinvesting has changed. This market
is still one of the most trustworthy places to put your
Municipal defaults are rare. According toMoody's , there was
an average of 4.6 a year from 2008 through 2012. Although that is
up from an average of 1.3 per year from 1970 to 2007, in a
universe of 1.5 million bonds outstanding, it's minuscule.
||The City of Detroit defaulted on two bond payments
before declaring bankruptcy this week.
As for defaults this year, Merrill Lynch expects that $573.2
million worth of municipal bonds will not meet their obligations.
In context, that is 0.6% of the $3.7 trillion of municipal bonds
outstanding, compared with 1.01% for all of last year.
Municipal bondsoffer higherincome thaninvestment banking . For
example, an AAA-rated tax-free bond maturing in 10 years yields
2%. For an investor in the 35%federal tax bracket , that's
equivalent to 3% from ataxable bond . Not bad when you're lucky
to get 1% from a CD.
A key benefit of municipal bonds: The steady income stream
doesn't fluctuate with the "value" of the bond in the resale
market. And, if you hold an individual bond tomaturity , you get
back theface value if theissuer can make good. Rising interest
rates will not affect you.
Types Of Muni Bond Risks
Even with Detroit's defaults and bankruptcy,default remains
extremely rare. However, you can further insulate yourself
fromcredit risk by concentrating on two things: The type of bond
and itscredit rating .
The safest type of municipal bond is thegeneral obligation
bond , which is paid back with taxrevenue the municipality
collects. General obligation bonds in general have the lowest
default rate. According to Moody's, only five generalobligation
defaults have occurred in the past 41 years, and no state has
defaulted since 1933.
Conversely, investors should generally avoidrevenue bonds ,
which are paid back by a project's fees.
Source: FMS Bonds
Investors should consider municipals with the highest credit
rating, AAA. Credit ratings are noguarantee , but no credit
rating is ared flag. Part of what helps bonds achieve an
AAArating is that they are insured, which will help make
investors whole in the event of a default.
Fund investors should stick to funds that hold securities
rated A to AAA. Consider
Vanguard Intermediate-Term Tax-Exempt Fund (
, as its
is about five years. Moreover, 95% of its portfolio is rated A or
Interest rate risk:
Rising interest rates only affect the value of municipal bonds
selling in the market. Thecash flow (income) remains unaffected.
Furthermore, interest-rate risk increases the longer a bond is
Note that risk can be extreme. A 1-point rise in the interest
rate could cut 10% of a municipal bond's value with a long
Consider bonds with relatively short-termmaturities if you
need tocash out. For example, if market rates rise, a bond
maturing in two years will decline less than a bond maturing in
five years. However, by owning shorter-term bonds, you'll earn
less interest income, so you're trading yield for less
Fund owners should know theirfund 's duration. This is also a
good time to snap up bargains. Consider
Vanguard Limited TermTax Exempt Fund (
Call Risk :
Thecall option has a huge impact on why municipal bonds are so
interest rate-sensitive. Call risk is primarily an issue if you
don't want to receive yourprincipal early and are counting on the
cash flow. Note that bond calls are less likely when interest
rates are stable or moving higher.
Research a bond'scall provisions if you're purchasing to
secure steady income. A typical 10- to 12-year muni bond will
have a 5%coupon , which means it will almost certainly be called
within three to four years. That is, as soon as the issuer can
refinance the bonds.
For the past 100 years, there has been a federaltax exemption for
purchasers of municipal bonds. If a new tax on tax-free bonds is
passed, this will obviously make municipal bonds less appealing.
Many investors have been willing to accept lower interest rates
because of the exemption. Mitigating this risk maymean a complete
overhaul of your financial portfolio.
Action to Take -->
With the municipal bond market undergoing changes -- even if it's
not an Armageddon -- there is a silver lining for committed
buyers. Any increase in rates will ultimately pare backnew issues
, supporting prices and allowing investors to build income
streams with higher coupons. Bonds are not immune to risks, but
investors can continue using them as a conservative tool for
steady income and (for now) a tax-efficient portfolio.