Last updated on October 5th, 2021
Last updated on October 5th, 2021 at 06:49 pm
Municipal bonds are generally tax free as we mentioned in the first couple of parts to this series. There are taxable municipal bonds, but we will leave a discussion of those for another section.
Defaults
Like other bonds one of the main risks of holding municipal bonds is the risk of default, the risk of default has been consistently low, in fact much lower than corporate bonds here is a comparison of default rates based on Moody’s credit rating[1]:
One study looked at the historical municipal defaults from 1800 to the 1800s finding that municipal defaults follow downswings in business cycles and tended to occur in high growth areas.
Categories of Municipal Bonds
Municipal bonds can be broken down into two main categories; General Obligation Municipal Bonds (GO’s) and Revenue Bonds the main difference is that GO’s are backed by the full taxing power of the entity that issue them and revenue bonds are backed by a specific stream of revenue from a project for example an airport, stadium, hospital, or sewer project. Generally, GO’s are considered safer that Revenue bonds. In fact, from 1970-2011 when there were 71 defaults only 7% or 5 where GO bonds and the rest were revenue[2]
The most infamous default cases involving general obligation bonds include New York City’s default in 1975 and Cleveland in 1978. The largest default in the history of the municipal bond market was the Washington Public Power Supply System’s (WPPSS) default on $2.25 billion in bonds. WPPSS launched a risky program to build five nuclear power plants in the 1970s to supply electricity to the Pacific Northwest. Only one of the five planned nuclear plants was ever completed. The WPPSS fiasco gave a lot more credibility to concerns that tax-exempt bonds were not a completely safe bet.
Within municipal bonds, general obligation bonds are considered the safest, since they are backed by the full faith, credit and taxing powers of the government that issued the bonds. Some jurisdictions may be in better financial shape than others. There are also fewer risks during economic upswings when governments usually collect more revenues from taxes.
Revenue bonds are considered riskier than general obligation bonds because repayment is dependent on specific revenue streams, such as user fees or lease payments. Revenue bonds issued for private institutions such as hospitals are even more risky. If the institution goes bankrupt and is unable to meet its debt obligations, the government or agency issuing the bonds for the companies is not under any legal obligation to repay the debt.
Though municipal bonds are considered safe, as in any other any investment, they have some risks. The two major risks include:
Credit risk – This occurs when a government entity issues bonds and then runs into economic and/or political problems, making its unable to pay the interest or return the principal. Bondholders can protect against credit risks to a large extent by checking the credit rating of a bond issue and/or making sure that the bond is insured.
Interest risk – Since bonds are fixed-income investments, municipal bond prices are inversely related to interest rates. Individual investors cannot really do much about interest rate risks other than be aware of the fact and decide on his/her threshold for rate changes.
Default risk – In the event of a default, bondholders seldom lose all their principal value of the bond. Often, a default could result in the suspension of the coupon payment. Defaulted bonds can become speculative as they can be purchased cheaply. If the issuer files for bankruptcy but reemerges successfully, then anyone who purchased the bonds when the company was in default stands to gain from the transaction.
The financial problems of some states and municipalities have been growing for decades as unfunded obligations for pensions and health care have ballooned in anticipation of a crisis sometime in the future.
Should you Buy Municipal, Bonds?
Of course, for tax-deferred accounts it makes little sense in most case to consider tax free municipal bonds, you may want to consider taxable municipals for those accounts or some other type of taxable bond.
The decision for taxable accounts hinges on a couple of factors, your marginal tax bracket, and the yield on municipal bonds in relation to taxable bonds. Marginal tax bracket means how much tax you pay on each additional dollar of income you receive. If you pay $.22 in tax on an additional dollar of income you are in a 22% marginal bracket. You will want to calculate the “taxable equivalent yield” (TEY) using that number and the yield on the municipal bond. Here is the formula:
Tax Equivalent Yield: •
Taxable Equivalent Yield=(Municipal Bond Yield)/(1-Marginal Tax Rate)
In our example if the yield on the municipal bond is 1% you would calculate the TEY as .01/.78 = 1.28%. That is the “hurdle” the yield on a taxable must exceed for it to make sense to buy a taxable bond instead of a municipal bond.
Of course, your marginal tax bracket can change, your “taxable” income can increase, or it can decrease, in many cases when you retire it can decrease dramatically at least until you are required to make withdrawals from your IRA’s (age 72), and you claim Social Security. If you are only 2-3 years away from retiring and you project you will be in a much lower tax bracket you do not want to buy Municipal bonds with a maturity longer than that or perhaps you can, but you may consider selling them if you are in a low enough bracket that taxable bonds provide more after-tax income.
So, you see the decision is not always as simple as calculating your current marginal bracket.
In the future we will be covering more advanced topics relating to municipal bonds and bonds in general. We will cover “pre-refunded” bonds, Municipal bonds that are “insured” and call features. Topics that relate to all bonds will include duration and yield to maturity at cost vs yield to maturity at market.
We discuss this in our YouTube Video:
[1] Source: Moody’s Investors Service, as of 7/15/2020.
[2] https://www.municipalbonds.com/education/read/77/default-rates-of-municipal-bonds/
