Municipal Bonds—Important Considerations for Individual Investors

Municipal securities—including municipal bonds or "muni bonds"—are securities issued by states, cities, counties and other governmental entities to raise money to build roads, schools and a host of other projects. Municipal securities also include bonds issued by a governmental entity, referred to as the "conduit issuer," to finance a project to be used primarily by a third party, a for-profit entity or a non-profit entity, such as a 501(c)(3) organization, referred to as the "conduit borrower."

 

FINRA is re-issuing this Alert to remind investors that while munis have historically been considered relatively conservative investments, they do, like all bond investments, carry risk:

  • Defaults, while quite rare, do occur.
  • Information about financial problems that affect the bond's issuer has not always been readily available to investors.
  • The current market value of a municipal bond may be hard to determine because many municipal bonds trade infrequently.
  • A bond's market value may change for reasons having nothing to do with the financial condition of the issuer, such as a change in interest rates.
  • In cases where an issuer has purchased bond insurance or some other protection feature, the higher overall credit rating of a bond may be more reflective of that protection than of the financial condition of the issuer.

Investors considering an investment in municipal bonds should bear in mind that no two municipal bonds are created equal—and they should carefully evaluate each investment, being sure to obtain up-to-date information about both the bond and its issuer. This Alert describes the basics of municipal bonds, lists smart tips for considering a muni investment and provides links to helpful information resources—including a new resource Municipal Bonds: Information Sources At-a-Glance.

 

Types of Municipal Bonds

 

There are three common types of municipal bonds:

  • General Obligation Bonds, referred to as G.O. bonds, are issued by states, cities or counties. They are backed by the "full faith and credit" of the government entity issuing the bonds. The creditworthiness of G.O. bonds is based primarily on the economic strength of the issuer's tax base.
  • Revenue Bonds are generally backed by fees or other revenue generated or collected by a facility, such as tolls from a bridge or road, or leasing fees. Bonds that are backed by a specific tax or assessment of a government entity, such as a tourist tax or other special tax or assessment, also are often considered to be revenue bonds. Unlike G.O. bonds, revenue bonds are not backed by the full faith and credit of the government entity issuing the bonds. Instead, the creditworthiness of revenue bonds depends on the financial success of the specific project they are issued to fund, on the revenues of a specific operational component of the government entity, or on the amounts raised by a specific tax or special assessment.
  • Conduit Bonds are a type of revenue bond often issued to fund a private entity with a public purpose, such as a not-for-profit hospital or an affordable housing development. One common structure is for the private entity to use a governmental issuer—a city, state or instrumentality of a state, for instance—as a "conduit" for the financing of such projects. Bond proceeds are loaned to the conduit borrower, which is responsible for repaying the loan to the issuer for repayment to the bondholders. Investors should be aware that if the conduit borrower fails to make loan repayments, the governmental issuer typically is not required to make up such shortfalls. Therefore, unless the bond documents explicitly state otherwise, investors in conduit bonds should not view the governmental issuer as a guarantor on conduit bonds.

Investors can buy and sell municipal bonds when they are initially issued ("primary offerings") or in the secondary market through banks and FINRA-registered investment firms. These organizations must also be properly registered with the U.S. Securities and Exchange Commission and the MSRB. It is important to work with an investment professional and investment firm you trust. The investment firm and investment professional should have experience in buying and selling municipal securities and must be able to explain the risks and features of such securities to you before you make a purchase.

 

Default Risk

 

When it comes to evaluating a municipal bond, a major focus should be on the issuer's ability to meet its financial obligations. A key question to ask is: How likely is the bond's issuer to default? This is referred to as "default risk."

 

One way to evaluate an issuer's default risk is to assess its financial condition. When a muni bond issuer offers a new bond for sale, it usually discloses the details of the offering and information about its financial condition in the bond's "official statement" (similar to the prospectus used for corporate securities offerings). Certain financial information may be updated annually and periodically through "event notices" concerning, for example, delinquency in principal and interest payments, other types of defaults, rating changes, events affecting the tax-exempt status of the bond, bond calls and other events (periodic financial disclosures and material and other event notices are referred to as "continuing disclosures").

 

The financial condition of the issuer may change over time and it is important to monitor the changes because they may affect the ability of the issuer to meet its financial obligations. The MSRB's EMMA website (www.emma.msrb.org) allows investors to sign up to receive alerts about the availability of important information that may affect their municipal bonds.

 

The MSRB makes official statements and continuing disclosures submitted to it by issuers and others available to the public for free through its EMMA website. EMMA also provides municipal securities trade price information through its Real-time Transaction Reporting System ("RTRS") and free public access to certain municipal credit ratings.

 

Investor Tip: Ask Your Broker About Disclosure—Brokerage firms and banks that sell muni bonds are required to have procedures in place to obtain material event notices and other disclosures. Ask your broker if a bond's issuer is up to date with its reporting of its annual financial/operating data. Treat missing or past due financial information as a potential red flag.

 

Credit ratings can help you evaluate a bond's default risk. However, it is important to realize that these ratings are opinions of the ratings organizations that issue them as to the likelihood that an entity will meet its financial obligations in full and on time. Ratings should be one of many factors in evaluating a municipal bond investment. Because ratings can change at any time, do not assume the rating shown on the official statement when the bond was first issued remains in effect if you buy the bond at a later date. Be sure to ask your investment professional for the current published ratings on any bond you are considering (and any bonds in your portfolio).

 

A high credit rating is not a seal of approval and neither reflects nor guarantees stability of market value or liquidity. In other words, a high rating does not mean that you will be able to sell an investment when you want or need to—particularly if you sell before the bond matures—or that you'll get the price you expected.

 

That said, a low credit rating (or a security without a rating) may very well be a sign of a bond's increased risk of default or an indicator of other risks. As such, a low credit rating should not be taken lightly. So-called "high yield" municipal securities often have low or no credit ratings—the higher return is meant to compensate investors for the higher level of risk they incur. Not all bonds have credit ratings. While an absence of a credit rating is not, by itself, a determinant of low credit quality, investors in non-rated bonds should be prepared to make their own independent credit analysis of the bonds. If you are unable to do so, ask yourself if the assumption of greater risk is worth the higher yield these bonds may carry.

 

Bond Insurance and Credit Ratings: A small percentage of municipal bond issuers include a repayment protection feature—most often bond insurance—to insure their bonds at the time they are issued. A bond with insurance generally is able to come to market with a higher credit rating, making the bond more attractive to buyers, and at the same time lowering the issuing cost to the municipality. The protection can shield an investor from default risk to the extent that the protection provider promises to buy the bonds back or to take over payments of interest and principal if the issuer defaults.

However, any guarantees are only as sound as the protection agent/insurance company that makes them. For this reason, when considering an insured bond, be sure to take into account the credit rating and long-term viability of the bond insurer.

 

Interest Rate Risk

 

Municipal bonds are also subject to interest rate risk, which is the risk that an increase in interest rates may reduce the market value of a bond you hold. Interest rate risk—also referred to as market risk—increases the longer you hold a bond. This is especially true if you purchase a bond when interest rates are at or near historically low rates, as they have been recently. Rising interest rates generally make new bonds more attractive because they earn a higher rate of return. Interest rate risk and other risk factors are described more fully in FINRA's Smart Bond Investing and FINRA's Investor Alert, Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio.

 

Smart Tips

 

Your overall investment strategy should be based on a number of factors, including how much risk you are willing to take, the purpose of your investment (income, growth or some of both), your investment horizon (when do think you will need the money) and whether it's a good fit with other investments in your portfolio. These smart tips can help muni investors protect themselves:

  • Check out the investment professional and the investment firm. A securities salesperson must be properly licensed, and his or her firm must be registered with the SEC, MSRB and FINRA. Use FINRA BrokerCheck or call toll-free (800) 289-9999 to learn about the background of your investment professional and investment firm. To confirm the MSRB registration of the investment firm, you can review the registered dealer list on the MSRB's website (www.msrb.org).
  • Don't reach for yield. Greater yield will generally mean greater risk. In a low interest rate environment, you may be tempted to purchase investments with greater yield. Be prepared to assume greater risk with these investments or, if you are not comfortable with the greater risk, avoid them.
  • Read the Official Statement. Ask your investment professional for information about the municipal security before you purchase it. The bond's Official Statement contains important information regarding the risks and features of the security. Be aware that an Official Statement may not be prepared for offerings less than $1 million in size and for certain offerings sold primarily to institutional investors. Also, if the security has been outstanding for a period of time, the information in the Official Statement may not be current.
  • Know a bond's duration. Duration signals how much the price of your bond investment is likely to fluctuate when there is an up or down movement in interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates. To find a bond fund's duration, look in the fund's Fact Sheet. For the duration of an individual bond, ask your investment professional.
  • Keep up with important information about the issuer. An issuer's financial circumstances may change over time. Stay abreast of changes to underlying economic factors, a bond's credit worthiness, and the issuer or obligated person's financial capacity. Ask your investment professional how current the issuer or obligated person is with its disclosures—and be aware that an issuer or obligated person's failure to furnish current information about its financial situation is a potential red flag. You may access continuing disclosures for free using EMMA.
  • Evaluate a bond's price. Bonds are generally issued in multiples of $5,000, referred to as a bond's face or par value. But they can trade above or below par in the secondary market for many reasons, including changes in current interest rates or the real or perceived credit quality of the issuer or obligated person. Use FINRA's Market Data Center or MSRB's EMMA website to check a bond's trading history, including how actively the bond trades (many trade infrequently) and recent pricing. If the issuer or obligated person has filed an event notice but has bonds trading at or above par, ask why.
  • Do your homework. Before buying any municipal bond, carefully consider the financial condition of the issuer and any other party that is responsible for payment on the bond. For revenue bonds, ask whether the revenue has been enough to cover the payments it must make on the bond (also known as the "debt service ratio"). With all municipal securities, ask your broker about the bond's call schedule and credit rating.
  • Do the tax math. Run the numbers (or ask your investment professional or tax advisor) to determine whether buying a tax exempt municipal bond, particularly from an issuer in your home state, makes sense for you.
  • Diversify. Market risks can be mitigated to a certain extent by diversification among different asset classes and within the same asset class. When diversifying within the muni bond asset class, consider diversification by issuer, location and maturity date. One way to diversify your municipal bond holdings is by investing in a municipal bond mutual fund or municipal security ETF. Be sure to research the securities in a given mutual fund or ETF, as well as maturity lengths (longer maturities usually mean greater risk). Be aware that bond funds and ETFs may invest in a narrow group of holdings (only tax-deferred bonds, for instance) and so your diversification may be limited. Bond funds and ETFs can decline in value, and prices fluctuate. Read the prospectus carefully before investing.

 

Additional Resources

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Last Updated: 4/24/2013