What are Municipal Bonds?

Q:What are municipal bonds?

A:Municipal bonds are debt instruments issued by municipalities in any of the 50 states by the following entities: 1) territories, subdivisions, counties, cities, towns and villages of the state, 2) school districts, 3) agencies such as authorities and special districts created by a state and 4) certain federally sponsored agencies, such as local housing authorities. Historically, the interest paid on these bonds has been exempt from federal income taxes and is generally exempt from state and local taxes in the state of issuance.

Types of municipal bonds

The two primary municipal types are general obligation and revenue bonds. General obligation bonds are secured by the full faith and credit of the issuer and are generally paid through ad valorem (assessed value) property taxes. Revenue bonds are not backed by the full faith and credit of a municipality; instead, they are backed by a specific revenue stream such as water and sewer revenue or highway tolls.

Considerations when evaluating a municipal bond

It’s important to evaluate the credit rating and the sector of the bond. A bond’s credit rating provides information about the anticipated credit risk, which refers to the issuer’s ability to repay bondholders. The highest-quality bonds have a credit rating of at least Aa3/AA–. As far as evaluating the sector, numerous default studies have shown that certain bond sectors have historically had higher default rates than others. This is demonstrated in the chart below. It’s prudent to avoid higher-default sectors such as housing and health care and focus on safer sectors such as general obligation and essential-service revenues bonds, such as water and sewer or infrastructure projects. If a bond clears these first two screening hurdles, the next step is to review the financials of that municipality to see if there are any negative financial trends or underfunded pension issues that might not be reflected in the rating but could cause fiscal stress in the future. A final consideration is to evaluate where a bond is trading compared with its peers. If the bond is trading at a much higher yield than its similarly rated peers, that will send a signal that the market is pricing in additional risk that might not be seen on the surface.

Municipal Default by Sector, 1970–2012 (Source: Moody’s)

SECTOR

# of Defaults

%

SECTOR

# of Defaults

%

Housing

29

39.7%

Water and Sewer

2

2.7%

Hospitals/Health Providers

22

30.1%

Counties

2

2.7%

Infrastructure

4

5.5%

Special Districts

0

0.0%

Education

3

4.1%

State Governments

0

0.0%

Cities

3

4.1%

Pool Financings

0

0.0%

Utilities

2

2.7%

Other

1

1.4%


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