Municipal bonds (munis) are often regarded as a safe-haven for investors due to the high credit quality of municipal governments. While they are less risky than many bonds, there are some risks that investors may want to carefully consider when selecting munis bonds for their portfolio. Some of these risks may not be entirely obvious on the surface, but they can become quite costly when they’re ignored and eat into an investor’s total risk-adjusted returns.
In this article, we’ll take a look at three munis bond risks that investors may want to consider when building their municipal bond portfolios.
Tax Risks
Municipal bonds are often considered to be tax-advantaged, since interest on the bonds are usually exempt from state income taxes. While this is true for most munis bonds, there are certain cases where interest payments may not be tax exempt. Bonds designed to support not-for-profit 501©(3) organizations, for example, are subject to the federal alternative minimum tax (AMT) for federal tax purposes. This could result in an unexpected tax bill for investors.
When looking for munis bond opportunities, investors should seek out so called AMT-free munis bond funds, or check the prospectus for individual munis bonds to make sure they’re not subject to the AMT before purchasing them. Investors with existing bonds may also call up their securities firm and talk with an account representative to get current information on their existing holdings and ensure that they’re not subject to these tax risks.
Liquidity Risk
Many investors may be accustomed to buying and selling stocks at the quoted price with the click of a button on their brokerage’s website. When it comes to the municipal bond market, most bonds are valued using an “estimated price” which is determined from trading history and other market data. Investors looking to sell their bonds ahead of expiration may have a difficult time determining how much they are worth and getting a good price for them.
Investors can avoid these issues by purchasing munis bond exchange-traded funds (ETFs) that have more liquidity and trade on stock exchanges. Since many other investors are purchasing these ETFs, the market has a lot more liquidity than the underlying munis bond market. Those investing in individual munis bonds can check the bid-ask spread to get an idea of how much liquidity is in the market–but less than 1% of securities account for half of all transactions.
Credit Risk
Municipal bonds are often regarded as extremely safe investments, since they are often backed by infrastructure revenue or income tax. While defaults are rare, there are instances where municipalities have defaulted, such as Detroit’s bankruptcy. Commonwealth nations (like Puerto Rico) also carry greater credit risks given the lack of bankruptcy protection from the United States federal government, which warrants careful consideration by investors.
In general, investors should consider using munis bond funds in order to diversify their risk across many different municipalities. Those investing in individual munis bonds should carefully examine their credit ratings when making a decision, while avoiding the temptation of high yields that may be indicative of higher risks. Sticking to highly-rated munis bonds or a portfolio of high-yield munis bonds tend to yield the greatest risk-adjusted returns.
The Bottom Line
The municipal bond market may be often regarded as a safe-haven for investors—but there are many risks that should be carefully considered, including tax risks, liquidity risks and credit risks that we’ve outlined in this article.
