Risk in Tax Free Municipal Bonds (Munis)

As you might’ve heard there was a lot of unrest in the Muni market due to the comment uttered by a a well known analyst regarding the possible collapse of municipal debt, which she predicted could happen any time.  The basis for this warning was the fact that municipalities are not required to issue audit financials for 3 years at a time.  She said that many well rated municipalities might be in financial trouble but the information will not get to analysis and investors until it may be too late.  Since then there were a few up and downs in the muni markets and now they are stabilizing.

When you seek your tax protection be sure you are not taking on too much credit or interest rate risk.  Credit risk may have to do with the bond rating.  Interest risk may be the “devil in the details” be sure you look for the real yield on the bond not the “coupon it’s paying.  What you as a consumer should know before getting into munis are the following facts:

1) Some munis are rated indirectly, in other words the rating is not issued for the municipality but for an insurer that “sold” performance insurance to the municipality.  And unless the municipality is required by the bond document to maintain this “wrap around” insurance they may let it expire and you will have an unrated municipal bond on your hands.  Unrated bonds are not as liquid (can’t be as easily sold) as rated bonds.  Furthermore, they will trade a significant discount (under par – Par is 100 and for bonds usually $1,000 increments) and unless held until maturity may cost you in losses v the additional income you might’ve gained from tax free interest.

2) If your muni is trading at a premium (over par, for example at $108) due to a favorable yield be sure to review the terms.  If it is callable it may be prepaid by the issuer and you might lose the premium you paid.  Keep your eyes on “yield to worse”, meaning the true yield you will earn by buying your bond at a premium and holding t until the next call date?  (This is something your bond trader will be able to show you).

Ask questions before buying a bond product.  There are many better and safer alternatives to municipal bonds suitable for even the most conservative investors.

Resources:

Word News: http://wn.com/Meredith_Whitney