A municipal bond, also called a muni bond, is an investment in a city. Local governments offer them in order to fund numerous city projects. Municipal bonds can be used for infrastructure items like roads, bridges, sewers, and necessary buildings like schools, hospitals, and prisons. Sometimes they are even used to build tourism structures like stadiums. The decision to invest in a municipal bond should not be taken lightly and should be researched as much as any other investment decision.
In order to understand the risk involved with a muni bond, it is important to understand how the bonds work. An investor gives cash to the city. In exchange, the local governments pay interest to the bondholders about every six months. This interest is federal tax free and often even state and local free if the muni bond is purchased by a resident of the state or city being funded.
Historically, muni bonds have been seen as a safe investment. Less than 1% of municipal bonds have defaulted since World War II. The bonds are backed by local government, which in many cases means they can raise the money needed to pay their debts through extra taxation.
There are three types of municipal bonds. General obligation bonds have the lowest rate, but are considered the most secure. They are a promise in good faith to repay the debt. Revenue bonds promise their payments from a specific revenue source, like from city run utilities. Assessment bonds get their payments on the property taxes of the properties located within the city limits.
With many big name magazines backing muni bonds in 2009 as a safe alternative to stock investment, many United States citizens began questioning if the bonds were as safe as they appeared. For comparison's sake, stocks between 1926 and 2009 averaged a 9.6% return, or about 7% post taxes. Muni bonds in 2009 were ranging in the 8% tax range. Also in 2009, the muni bond had a higher yield than Treasury Bonds for the first time in over 50 years. Several large banks also closed in 2008, leaving some questioning the safety of plain savings accounts. Compared to these fluctuating investment alternatives, the muni bond sounded like a safe investment to many.
Defaults by municipal bond issuers are extremely rare, but they do happen. In tough economic times, these defaults are more likely to occur. Much of the safety and value of a muni bond has to do with the perceived ability to repay the debt, a perception that changes when the economy is sluggish. Cities get their revenue to repay the bonds through income tax, sales tax, and property tax. If people are out of work and not buying products, the city's revenue will decrease, as will the value of the bond.
Major independent companies like Standard and Poor's, Moody's, and Fitch rate municipal bonds. According to these sources, a credit rating of BBB, Baa or better are usually considered good for investment. Most experts agree that these ratings are not always accurate and other factors always need to be considered.
There are a couple of ways to quickly preclude a muni bond. An unstable tax base is a bad thing, since most of the revenue to pay the bonds is raised through taxes. Taxes should not have a consistent history of fluctuation. Also, the higher the interest rate offered on the bond, the more risky the investment. Lower interest rates offer less yield, but greater safety during tough economic times.
When choosing a municipal bond, investors should take a good look at the issuers official statement. These mandatory disclosures tell investors all of the financial information necessary to see if a bond looks safe. Words like "tender-option," "inverse," and "derivative" are key words that mean a bond is not as stable as other options. A portfolio turnover of 50% or more indicate excessive trading and therefore unstable bonds. Whenever an investor is unsure, the best bet it is consult an investment adviser who can help them to decide the best route of action.