Asset Focus: Municipal Bonds

In this latest instalment of our series on investments that produce monthly income, we are talking Municipal Bonds. What are they?, how to invest, and what do returns and risk look like in 2021 and beyond?

What Are Municipal Bonds?

A Municipal Bond – also known as Muni bonds – is a debt obligation issued by certain governmental entities, including local and state government departments.

Muni bonds are issued to raise funds to fund public works. These include local parks, libraries, roads and other infrastructure. Most of these types of bonds tend to pay distributions to bondholders every six months, making them a useful tool for investors looking to build an investment portfolio that pays monthly income.

Much like other types of bonds, there are a handful of different types of municipal bonds. Here is a little more detail.

General Obligation Bonds

A general obligation bond is that is backed by the issuers tax revenue and other income. There are no assets used as collateral for a general obligation bond. They are issued on the expectation that the issuer will have sufficient revenue from tax and other sources to repay bondholders.

Local governments issue municipal bonds to pay for ongoing costs and infrastructure projects

Government’s offer pledges of tax and other revenue when issuing municipal bonds. For example, a local government could pledge to levy property taxes to repay bondholders. Pledges can be limited or unlimited.

A limited-tax pledge allows government to increase property taxes if required to pay for existing debt obligations. But, there is a statutory limit as to how much taxes can be raised, so the bond issuer might have to use other revenue to pay back investors.

An unlimited-tax pledge allows for a local government to raise property taxes to whatever amount is required to cover delinquencies from other taxpayers. They cannot do this at will however. Residents first have to agree to raise property taxes to the level required for the bonds.

Revenue Bonds

In contrast to a general obligation bond, a revenue bond is supported by the revenue accumulated from a specific project. This can include income-generating projects like a toll bridge, highway or a local sports venue.

Municipal revenue bonds repay investors from the revenue of an underlying project

There are several types of municipal revenue bonds, including:

  • Airport revenue bonds
  • Toll revenue bonds
  • Hospital revenue bonds
  • Mortgage revenue bonds
  • Industrial revenue bonds

Revenue bonds tend to be issued in $5,000 units, with maturities of 20 to 30 years. Governments can issue revenue bonds as a way to raise capital without reaching their mandatory debt limits which generally apply to more traditional credit such as bank loans.

How to Invest in Municipal Bonds

There are a few ways to invest in municipal bonds. You can buy them from a bond dealer, bank, or broker. Or, if you’d rather not pick and choose your own bonds, you could invest in a mutual fund or ETF (exchange-traded fund).

If you are taking the fund route, your investment will benefit from exposure to all of the individual bonds that are held within the fund. As such, bond mutual funds and ETFs add an element of diversification to your bond allocation.

Exchange traded funds can be a great way to invest in basket of assets

Because bond ETFs trade on a stock exchange, they offer a more liquid and accessible way to invest in municipal bonds than investing directly in the bond market. Bear in mind though, mutual funds (and some ETFs) are managed by a professional fund manager, so they often have additional costs and fees to consider.

What Are the Returns for A Municipal Bond?

Returns to specific municipal bonds vary greatly. According to the Bloomberg Barclays Municipal Bond Index, municipal bonds have delivered annual returns ranging from 0.2% to 9.1% over the past 5 years. Some governments issue tax-exempt municipal bonds, and for obvious reasons these are quite popular with investors seeking tax-efficient income.

While returns to municipal bonds are certainly not stellar – you’re not going to get rich investing in local government debt – they are considered relatively safe investments. Which brings us nicely on to the final part of this article, risk.

What Are the Risks of Investing in Municipal Bonds?

As specified before, municipal bonds are considered fairly low risk compared to some other debt securities (except US treasuries of course). However, it should be noted that while a municipal bond is low risk, they are not entirely risk-free. As with any type of debt security, there are two main areas of risk to consider.

Municipal Bond Credit Risk

The risk of borrower default – credit risk – is perhaps the biggest major concern for any bond investor. Return on investment is one thing, but return OF investment is something different altogether.

Like all investments, municipal bonds carry some degree of risk

While the default rate on municipal bonds is low compared to corporate bonds, there are many factors which can increase the risk of a borrower defaulting. Because such a wide variety of government bodies issue municipal bonds, credit risk definenitly plays a part in overall performance as a higher perceived risk of default manifests in higher potential returns.

Because general obligation bonds in particular rely on property tax revenue, a steep economic decline or housing market crash would significantly impact risk because property tax revenues would suffer. This is exactly what happened in 2008!

Municipal Bond Interest Rate Risk

The other major consideration for bond investors is interest rate risk. As with any bond investment, muni bonds carry risk associated with fluctuating interest rates. When interest rates rise, the price of bonds falls, and vice versa. Performance of the wider bond market is tracked in the Barclays Aggregate Index (BarCap Aggregate). When this index has been down, so too have returns to municipal bonds. When the index is up, the performance of municipal bonds tends to follow suit.

How does this play out in 2021? Well, interest rates are at historic lows, so the only way is up, which could impact the investment performance of bonds in general. But the question is, when? Personally, I think it highly unlikely that interest rates will rise any time soon. There is simply no political will to stop kicking the can down the road. Policymakers are likely to continue supporting the fake economy with low interest rates and trillions of dollars in freshly printed money.

Conclusion and Resources

Common wisdom states that bonds are appropriate for more conservative investors and retirees due to the lower-risk returns. But bonds are by no means a risk-free investment. While they there is less volatility in bond markets than the stock market, returns can and do fluctuate. And volatility, after all, is the enemy for most investors.

If you want to learn more about municipal bonds, you can further your research using the following resources: