Investors have flocked to municipal bonds in recent years, considering them to be a relatively safe haven. Despite their popularity, however, municipal bonds funds have their risks. Some experts believe that municipal bonds are poised to fall. Investors and their advisers need to understand the risks as well as the potential benefits of municipal bonds investments.
A municipal bond is a debt security issued by a city or other local government, or one of their agencies. There are several types of municipal bonds – general obligation bonds, revenue bonds and assessment bonds. In the event of default, a general obligation bond has recourse to all of the issuer’s assets and revenues, while a revenue bondholder has recourse only to the specified revenues that secure the bond, and assessment bonds are tied to property tax assessments.
Interest paid by municipal bonds is generally exempt from federal income tax and from certain state and local taxes.
Municipal bonds issued for special purposes, however, may not be tax-exempt. Investors may purchase individual municipal bonds or shares of a municipal bond fund. The price of a municipal bond typically varies as bonds are bought and sold in the secondary market. Absent a default or sale of the bond prior to maturity, however, an investor will receive full repayment of principal at maturity. An investor in a municipal bond fund, on the other hand, is subject to fluctuations in the net asset value of the fund as underlying shares are bought and sold.
Due to a persistently poor economy and lower tax revenues, many municipal bond issuers face challenges in balancing public spending needs with payment obligations. Meredith Whitney, who had correctly predicted the recent Great Recession, famously predicted massive defaults of state and local governments in December 2010. That has not happened (at least not yet), but financial luminaries like Warren Buffett, George Soros, and Nouriel Roubini (aka “Dr. Doom”) have also warned of trouble in the municipal bond market.
Adding to the concerns are: (i) a proposed elimination of the exemption from federal income tax of gains from municipal bonds; (ii) the Volcker Rule, which would limit proprietary trading by big banks and thereby reduce demand for municipal bonds; and (iii) a long municipal bond rally that has increased bond prices and lowered yields.
High-yield or junk municipal bonds and junk bond exchange-traded funds have also rallied, but experts warn that the increased yield may not be sufficient compensation for the increased risk inherent in such bonds. These bonds are often issued to finance projects such as nursing homes and hospitals, and are even riskier because they are usually revenue bonds, not general obligation bonds.
Small unrated municipal bonds whose coupons are not backed by tax revenues (so-called “mini munis”) are reportedly imbedded in some seemingly safe municipal bond funds. Thousands of them are missing payments. The performance of municipal bond funds that hold them may be impaired.
Bond values are not always easy to determine, however. Some mutual fund managers have been accused of over-pricing their bond portfolios to attract investors. The SEC noticed the problem and started an investigation into how bond funds price risk in their portfolios.
Other regulators are also concerned. Municipal bonds are one of the products in the Financial Industry Regulatory Authority’s (FINRA’s) watch list.
If you have investment losses or problems involving municipal bonds, call the lawyers at Page Perry for experienced representation at (404) 567-4400 or (877) 673-0047 (toll free).