Municipal bonds are often seen as a good opportunity to earn a higher yield compared to U.S. government bonds for tax-bracket investors. However, how much will you pay in terms of risks for that additional yield? In short, there isn’t as much risk as you might think, but there are always some risks to be aware of when investing.
Headline Risks
Headline risks refer to the dangers that arise from negative news being published. Municipal bonds face negative headline risks because prominent repayment assumptions tend to make news headlines. A prominent case of headline risk occurred in late 2010 when an analyst predicted that slowing economic conditions could lead to hundreds of billions of dollars in defaults among municipal issuers.
This forecast spooked investors and pushed the municipal bond market down by nearly 6% in the weeks that followed. When the market finally reached its lowest point two months later, it had lost almost 10% of its value since the interview.
Periods of decline in the municipal bond market linked to news could be a great investment opportunity in municipal bonds. This way, you can buy these bonds when prices are low, potentially earning a higher interest rate, or sell them when prices rise.
Interest Rate Risks
While default risk is low, municipal bonds are subject to interest rate risk, or the risk associated with rising interest rates and falling prices. This applies even more to investors in bond funds and exchange-traded funds that invest in municipal bonds. If Treasury yields rise (meaning prices decline), municipal bonds are very likely to follow suit. Investors will see a decrease in the principal value even if default rates remain low.
As a result, it’s important to ensure that the investment you choose aligns with your time frame, goals, and risk tolerance. When considering an investment fund, it’s advisable to take the time to understand how the fund manager has performed in down markets, what kind of track record they have, and the nature of the securities the fund invests in.
Low Default Risk and Low Rate
According to a study by the fixed-income rating agency Moody’s, the yields on municipal bonds adequately compensate investors for the additional risks. In the period ending in 2011, 100% of Aaa-rated municipal bonds returned all expected interest and principal payments to investors.
During the same period, 99.9% of Aa-rated bonds did the same. The ratings come from Standard & Poor’s ratings. Aaa is the highest possible rating; Aa is the second highest. Generally, very few municipal bonds default. Only 0.08% of municipal bonds defaulted between 1970 and 2021, and the average default rate for municipal bonds over a five-year period from 2012 to 2021 was 0.1%.
High-quality bonds tend to perform better than lower-rated securities even during periods of economic distress. This is due to the underlying issuers having sufficient financial strength to continue making payments even in unfavorable conditions.
Low Default Rate
You should keep in mind that the price of defaulting bonds doesn’t always go to zero. Investors can often expect some degree of recovery.
While municipal bonds carry their share of risks, there is enough evidence that the chances of default in the municipal bond market are very low. You can mitigate default risk on municipal bonds by focusing on high-quality securities.
Of course,
There is still a risk of municipal bankruptcy or the inability to pay bondholders, although it is low.
Conclusion
The risk that any individual municipal bond with a high credit rating will default is very low. However, anyone putting cash into an individual issue should do a lot of research. While it is helpful to know that defaults are rare, it is also important to keep in mind that there are other risk factors at play.
Frequently Asked Questions (FAQs)
What are the advantages and disadvantages of municipal bonds?
The interest you earn on municipal bonds is usually exempt from federal income tax. If the bond is issued by the state in which you pay taxes, you typically won’t have to pay taxes on the interest you earn. However, municipal bonds generally have lower interest rates than corporate bonds with similar terms.
What are the tax risks associated with investing in municipal bonds?
Although the interest is usually not taxable, capital gains are taxable. The interest earned on a municipal bond may also increase your social security taxes, and it can be considered part of the income that affects your monthly Medicare premiums. Additionally, if you purchase a municipal bond from outside your home state, the interest you earn may be subject to income tax, depending on the laws of your state.
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Sources:
– S&P Global. “S&P Global Ratings Definitions.”
– Seeking Alpha. “Muni Defaults: Should Investors Worry?”
– Charles Schwab. “Why Widespread Muni Defaults Are Unlikely to Happen.”
Source: https://www.thebalancemoney.com/the-risks-of-municipal-bonds-417146
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