NataliePace.com Home Page Article
Municipal
Bonds
—Staying
on the Safe Side of the Street in Rough Times.
An Investor Alert by
FINRA.org.
Municipal
securities—often called "muni bonds"—are bonds issued by states, cities, counties
and other governmental entities to raise money to build roads, schools and a
host of other projects for the public good. FINRA and the Municipal Securities
Rulemaking Board (MSRB) are issuing this Alert to remind investors that while
munis have historically been considered relatively conservative investments,
they do, like all bond investments, carry risk. As some state and local jurisdictions
struggle with the fall-out from current economic conditions, investors should
be aware that:
- 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 resources, including a new Investor
Checklist, FINRA’s Smart
Investing in Bonds and the MSRB’s EMMA
website, to help investors avoid some of the most common pitfalls of municipal
bond investing.
Muni
Bond Basics
Municipal bonds
generally pay a specified amount of interest (usually semiannually) and return
the principal to you on a specific maturity date. One key reason many individual
investors buy municipal bonds is the tax benefits: interest on the vast majority
of municipal bonds is free of federal income tax, and if you live in the state
or city issuing the bond, you may also be exempt from state or city taxes on
your interest income.
There are two common types
of municipal bonds:
- General Obligation
Bonds, referred to as GO 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 GO bonds is based primarily
on the economic strength of the issuer's tax base.
- Revenue Bonds
are backed solely 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 GO 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.
Historically, very few
muni bonds have gone into default. But defaults can occur. Defaults tend to
be higher for revenue bonds than for GO bonds—especially those that back private-use
projects such as nursing homes, hospitals or toll roads.
Investors can buy and sell
municipal bonds when they are initially issued or in the secondary market through
the approximately 2,200 FINRA-registered firms and banks registered with the
Securities and Exchange Commission as brokers or dealers in municipal securities.
It is important to work with a broker and firm you trust. The firm and broker
should have muni bond experience, and the broker should have the skills to conduct
an analysis of the credit quality of the municipal investment.
Risk
Factors
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"
(analogous to the prospectus used for corporate securities offerings). This
information is typically updated each year—and also from time-to-time through
"material events 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.
These disclosures have
historically been difficult and expensive for muni bond investors to obtain.
Unlike publicly traded companies that issue stocks and bonds, muni bond issuers
are generally exempt from registering their securities with the Securities and
Exchange Commission and do not file ongoing disclosures, including audited financial
statements, with any securities regulator. You may be able to get this information,
for a fee, through one of the Nationally Recognized Municipal Securities Information
Repositories (NRMSIRs).
The MSRB currently makes
official statements and other muni bond disclosures available to the public
for free through its Electronic Municipal Market Access (EMMA)
website. As of July 1, 2009, all ongoing disclosures submitted by issuers became
available to the public for free through EMMA, along with real-time trade pricing
and up-to-date interest rate information on variable rate and auction rate securities.
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Investor Tip:
Ask Your Broker About Disclosure—Under
SEC and MSRB rules,1 the brokerage firms and banks that sell
muni bonds are required to have procedures in place to obtain material
event notices and other disclosure. 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.
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Credit ratings can also
help you evaluate a bond’s default risk. However, it is important to realize
that these ratings are estimates only and should be only 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 broker for the current published ratings on any bond you
are considering (and any bonds in your portfolio).
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Ratings Rise:
A number of ratings agencies have indicated they plan to move to a uniform
ratings scale for all bonds. In the past, most ratings agencies have used
a separate, and more stringent, set of standards for rating municipal
bonds than corporate bonds. As ratings agencies employ this uniform standard,
investors can expect to see a rise in the ratings of thousands of municipal
bonds. Investors should not take this to mean these bonds have been deemed
to carry reduced credit risk. Rather, the improved rating reflects a method
of evaluating risk that is in keeping with the calibration used for corporate
bonds.
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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 may very well be a sign of a bond’s increased risk of default or an indicator
of greater liquidity risk and price level risk. As such, a low credit rating
should not be taken lightly. So-called "high yield" munis often have
low credit ratings—the higher return is meant to compensate investors for the
higher level of risk they incur.
|
Bond Insurance
and Credit Ratings:
Some muni 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. Following recent economic turmoil, the credit ratings
of most bond insurers have been downgraded—and, in many cases, the current
credit profile of the municipal bond issuer itself may now be higher than
the current credit rating of the bond insurer.
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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.
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Interest Rate
Risk. Muni
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.
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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 broker
and firm. A securities salesperson must be properly licensed, and his
or her firm must be registered with the MSRB and with FINRA, the SEC or a
state securities regulator—depending on the type of business the firm conducts.
For a broker or investment adviser, use FINRA BrokerCheck
or call toll-free (800) 289-9999. To confirm MSRB registration, contact MSRB.
- Don’t reach for yield.
Never make your investment decision based solely on a bond’s yield unless
you are willing to assume more risk. The higher return you are "reaching
for" is an indicator of increased risk.
- Read the Official
Statement. Ask your broker for information about the municipal security
before you purchase it. The bond’s Official Statement is where you will find
a bond’s important characteristics, from yield to the bond’s call schedule.
Be aware that an Official Statement may not be prepared for offerings under
$1 million and certain offerings sold primarily to institutional investors.
- Keep up with material
news, including updated financial information and material event notices.
An issuer’s circumstances may change over time. Stay abreast of changes to
underlying economic factors, a bond’s credit worthiness, and the issuer’s
financial capacity. Ask your broker how current the issuer is with its disclosure—and
be aware that an issuer’s failure to furnish current information about its
financial situation is a potential red flag. You may access on-going
disclosure filings submitted beginning July 1, 2009, 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. Use FINRA’s Market
Data Center or MSRB’s EMMA
to check a bond’s trading history, including how actively the bond trades
(many trade infrequently) and recent pricing. If the issuer has filed a distress
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 state, city or county that is issuing the bond and any other party
that is responsible for payment on the bond. For revenue bonds, ask whether
the issuer’s revenue has been enough to cover the payments it must make on
the bond (also known as the "debt service ratio"). With all munis,
ask your broker about the bond’s call schedule and see if the bond’s credit
rating has gone up, down or remained stable.
- Do the tax math.
Run the numbers (or ask your broker or tax advisor) to determine whether buying
a tax-free muni bond, particularly in your home state, makes sense for you.
For more information and a formula to help you compare yields, see Muni
Math in FINRA’s Smart Bond Investing.
- 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 muni bond holdings is to invest in
a muni bond mutual fund or muni ETF. Be sure to research the securities contained
in a given 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,
making it impossible to know the value of your holdings prior to sale.
Additional Resources
- MSRB Electronic Municipal
Market Access (EMMA)
website
To receive FINRA’s latest
Investor Alerts and other important investor information, sign up for Investor
News.
About FINRA
The Financial
Industry Regulatory Authority (FINRA), is the largest independent regulator
for all securities firms doing business in the United States. All told, FINRA
oversees nearly 4,800 brokerage firms, about 170,400 branch offices and
approximately 643,000 registered securities representatives.
FINRA believes investor
protection begins with education. Using the Internet, the media and public forums,
we help investors build their financial knowledge and provide them with essential
tools to better understand the markets and basic principles of saving and investing.
1 MSRB rules are enforced
by FINRA for securities firms, bank regulatory agencies for bank dealers, and
the SEC for all brokers, dealers and municipal securities dealers.
