While the risk of default is modest, muni bonds are vulnerable to interest rate risk, or the possibility that rising rates may cause prices to decline. This is especially true for investors in municipal bond funds and exchange-traded funds (ETFs). If Treasury yields rise (implying that prices fall), muni bonds are quite likely to follow suit. Even if defaults stay low, investors’ principal value will drop.
What happens if a municipal bond fails to pay interest?
Bondholders seldom lose all of their main value in the event of a default. The suspension of the coupon payment is frequently the outcome of a default. Defaulted bonds might become speculative due to their low cost of acquisition.
What are the potential dangers of municipal bonds?
Municipal bonds (also known as municipal debt) are a type of debt “State, city, county, and other local agencies issue debt securities to support day-to-day commitments as well as capital projects such as the construction of schools, roadways, and sewer systems. When you buy municipal bonds, you’re effectively lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or a combination of the two “I am the principle.” The maturity date of a municipal bond (the day on which the bond’s issuer repays the principal) could be years away. Short-term bonds will mature in one to three years, whereas long-term bonds will take a decade or more to maturity.
Municipal bond interest is generally tax-free in the United States. If you live in the state where the bond was issued, the interest may be free from state and local taxes. Bond investors are often looking for a consistent stream of income payments and, when compared to stock investors, are more risk conservative and concerned with preserving rather than developing capital. Due to the tax benefits, tax-exempt municipal bonds typically have lower interest rates than taxable fixed-income assets such as corporate bonds with equal maturities, credit quality, and other characteristics.
- States, cities, and counties issue general obligation bonds that are not backed by any assets. General obligations, on the other hand, are backed by the government “the issuer’s “full faith and credit,” which includes the ability to tax inhabitants in order to pay bondholders.
- Revenue bonds are backed by earnings from a specific project or source, such as highway tolls or lease fees, rather by the government’s taxing power. Some revenue bonds are available “The term “non-recourse” refers to the fact that bondholders have no claim to the underlying revenue source if the revenue stream ceases to exist.
Municipal borrowers also occasionally issue bonds on behalf of private businesses such as non-profit universities and hospitals. The issuer, who pays the interest and principal on the bonds, often agrees to reimburse these “conduit” borrowers. The issuer is usually not compelled to pay the bonds if the conduit borrower fails to make a payment.
Where can investors find information about municipal bonds?
The Municipal Securities Rulemaking Board’s Electronic Municipal Market Access (EMMA) website makes municipal securities documentation and data available to the public for free. You will have access to:
- Economic reports and events that may have an influence on the municipal bond market are listed on this calendar.
It’s worth noting that many issuers have dedicated websites or webpages for municipal bond investors. Some issuers link to those pages from their EMMA main page. Learn how to use EMMA to locate issuer homepages.
In 2009, the Securities and Exchange Commission recognized EMMA as the official depository for municipal securities disclosures. The MSRB is supervised by the Securities and Exchange Commission (SEC). The MSRB is a self-regulatory body whose objective is to promote a fair and efficient municipal securities market in order to safeguard investors, state and local governments, and other municipal entities, as well as the public interest. The disclosure materials are not reviewed by the SEC or the MSRB before they are posted on EMMA.
What are some of the risks of investing in municipal bonds?
Municipal bonds, like any other investment, carry certain risk. Municipal bond investors are exposed to a number of dangers, including:
Call it a gamble. Call risk refers to the possibility of an issuer repaying a bond before its maturity date, which could happen if interest rates fall, similar to how a homeowner might refinance a mortgage loan to take advantage of reduced rates. When interest rates are constant or rising, bond calls are less likely. Many municipal bonds are “callable,” thus investors who plan to hold a bond to maturity should look into the bond’s call conditions before buying it.
There is a credit risk. This is the risk that the bond issuer will run into financial difficulties, making it difficult or impossible to pay interest and principal in full (the inability to do so is known as “default”). For many bonds, credit ratings are available. Credit ratings attempt to measure a bond’s relative credit risk in comparison to other bonds, yet a high grade does not imply that the bond would never default.
Interest rate risk is a concern. Bonds have a set face value, which is referred to as the “par” value. If bonds are held to maturity, the investor will get the face value of the bond plus interest, which might be fixed or variable. The market price of the bond will grow as interest rates fall and fall as interest rates rise, hence the market value of the bond may be greater or lesser than the par value. Interest rates in the United States have been historically low. If interest rates rise, investors who hold a cheap fixed-rate municipal bond and try to sell it before it matures may lose money due to the bond’s lower market value.
There is a chance of inflation. Inflation is defined as a widespread increase in prices. Inflation diminishes purchasing power, posing a risk to investors who are paid a fixed rate of interest. It may also result in higher interest rates and, as a result, a decrease in the market value of existing bonds.
There’s a danger of running out of cash. This refers to the possibility that investors may be unable to locate an active market for the municipal bond, prohibiting them from buying or selling the bond when they want and at a specific price. Because many investors purchase municipal bonds to hold rather than trade them, the market for a given bond may be less liquid, and quoted values for the same bond may range.
In addition to the risks, what other factors should you consider when investing in municipal bonds?
There are tax implications. Consult a tax specialist to learn more about the bond’s tax ramifications, such as whether it’s subject to the federal alternative minimum tax or qualified for state income tax benefits.
Brokerage commissions. The majority of brokers are compensated by a markup on the bond’s cost to the firm. It’s possible that this markup will be revealed on your confirmation statement. If you are charged a commission, it will appear on your confirmation statement. You should inquire about markups and commissions with your broker.
How frequently do municipal bonds go into default?
With all of the high-profile municipal bond failures and scares in recent years, from Vallejo, California, to Harrisburg, Pennsylvania, it’s easy to get worried about the typically calm and stable muni bond market. So, with that in mind, I wanted to throw some numbers around about municipal bonds to assist quantify the risks associated with these assets.
Keep in mind that all of the numbers in this article come from one of four places: Standard & Poors, Moody’s, the New York Federal Reserve, and the MSRB (Municipal Securities Ruling Board).
Let’s start with rated municipal bonds, which are those that have been assigned a rating by one of the three major rating agencies: S&P, Moody’s, or Fitch. These bonds are often issued by larger companies and pay lower yields than unrated bonds. As most of you reading this are probably aware, the higher the grade, the lower the bond yields, provided that all other factors (such as maturity) remain constant.
There were 71 defaults on rated municipal bonds between 1970 and 2011, with 46 of these occurring after 1986. Approximately 11,000 municipal bonds were issued during the time period. This means that rated municipal bonds defaulted at a rate of 0.64 percent on average, or around 1 bond out of every 150 issued. This applies to all municipal bonds, including investment grade and non-investment grade, and we’re talking about the default rate for the bond’s whole life, not just one year.
What does it signify when a bond goes into default?
When a bond issuer fails to make interest or principal payments within the stated time frame, a bond default occurs. The most common cause of default is when the bond issuer runs out of cash to pay its bondholders. A restructure, which adjusts the terms of the loan, is frequently used to alleviate this situation.
A municipal bond can default.
The majority of municipal bonds do not default on their own. Typically, the issuers want to be allowed to break certain security restrictions and use reserve cash to make debt service payments, which causes a lot of stress for several years.
Are municipal bonds safe from default?
- Municipal bonds are a wonderful option for consumers who want to keep their money while earning tax-free income.
- General obligation bonds are used to quickly raise funds to meet expenses, whereas revenue bonds are used to fund infrastructure projects.
- Both general obligation and revenue bonds are tax-free and low-risk investments, with issuers who are quite likely to repay their loans.
- Municipal bonds are low-risk investments, but they are not risk-free because the issuer may fail to make agreed-upon interest payments or be unable to repay the principal at maturity.
Is it safe to invest in municipal bonds right now?
- Municipal bond interest is tax-free in the United States, however there may be state or local taxes, or both.
- Be aware that if you receive Social Security, your bond interest will be recognized as income when determining your Social Security taxable amount. This could result in you owing more money.
- Municipal bond interest rates are often lower than corporate bond interest rates. You must decide which deal offers the best genuine return.
- On the bright side, compared to practically any other investment, highly-rated municipal bonds are often relatively safe. The default rate is quite low.
- Interest rate risk exists with any bond. You’ll be stuck with a bad performer if your money is locked up for 10 or 20 years and interest rates climb.
Which of the following bond kinds has the lowest risk of default?
This set of terms includes (23) Which bonds have the lowest risk of default? Treasury bonds have no risk of default since the US Treasury can always generate new money to fulfill its debt if necessary.
Investment grade municipal bonds are very safe, but FDIC-insured CDs are safer.
Your money is federally protected up to $250,000 when you buy a CD from a U.S. bank. The federal government is practically guaranteeing that you’ll get your entire deposit back, plus any interest you’ve earned. This federal guarantee does not apply to municipal obligations. Municipal bonds have an extremely low default rate, yet they do default on occasion. Out of the approximately 10,000 investment grade bond issues graded by Standard & Poor’s, four defaulted in 2012. Defaults did occur, despite the fact that the number represented was less than 0.1 percent. Because CDs are safer than bonds, buying CDs instead of municipal bonds would make sense if the CDs offered the same or better after-tax returns.