Municipal securities are an important part of the fixed-income market. While small, at $4.2 trillion compared with the U.S. bond market at $52.9 trillion, municipal bonds are a critical financing vehicle for cities, towns and states. The lion’s share of municipal financing is for large, long-lived assets such as roads, bridges, hospitals and schools.
Investors in municipal securities are varied, with individuals making up 40% of outstanding securities as of Q2 2022.1 Mutual funds come in second, making up 28% of outstanding municipals.
Interest income that is received on municipal bonds is federally tax-exempt, and in some cases, state and locally tax-exempt. This feature has a double benefit: 1) as interest is tax-exempt, municipal issuers can issue bonds with lower interest rates than comparable corporate issuers, and 2) investors in a high tax bracket receive interest income that is tax free.
For reference, the calculation for an after-tax yield is as follows:
After-Tax Yield = Pre-Tax Yield x (1 - Tax Rate)
6% = 10% x (1 - 40%)
Municipal Market vs. Corporate Market
Municipals are considered conservative investments and generally have low credit risk. As they are backed by state or local taxes or revenues from local facilities such as bridges or tunnels, they tend to have reliable cash flows to pay both principal and interest. As such, municipals historically have had lower default rates than similarly rated corporate bonds. However, a number of municipalities have defaulted, including Detroit and Puerto Rico.
The differences between corporate and municipal debt are many—including tax treatment, default history, transparency and disclosure, number of issuers, financial flexibility, market liquidity and accounting rules. In addition, municipals are secured by the full faith and credit of the municipality or by a specific revenue stream while corporates may be secured or unsecured with specific assets.
Due Diligence Considerations
While the macro risks that affect municipal securities can differ from those that affect corporate, economic and governance risks do exist and investors should be aware of how well an issuer manages tax and revenue collection during all parts of the economic cycle. Changes in the Federal Reserve’s policy and tax rules should also be considered. As the Federal Reserve continues to raise interest rates and the threat of recession looms large, credit analysis will be more important when looking at municipal bonds. Higher interest rates will put additional cash flow pressure on municipalities.
Financial risks include credit risk, market risk, liquidity risk, operational and legal risk. When investing in municipals, economic factors such as industry concentration, local economic strength, and overall wealth and income levels of the population should be considered. The demographic profile of the population is also important to analyze, and the investor should ask questions such as “is the population increasing or decreasing,” “what is the age distribution of the population base” and “is unemployment increasing or decreasing.”
Let’s review the two largest types of municipal bonds—GOs and Revenue Bonds.
Local General Obligation (GOs) bonds are primarily backed by the local or state tax base. Some red flags to look for in GOs include a decline in property values, a decreased tax base and high foreclosure rates. Also, look for a decline in building permits coupled with a decline in the overall population base.
Revenue Bonds are backed by a specifically identified revenue stream such as tolls, airport and sewer fees. Some red flags to look for in revenue bonds include a decrease in coverage of debt service due to declining revenues, cost overruns and schedule delays on projects, and new or unanticipated competition.
In summary, there are some issues to consider that could threaten municipal bonds as an investment. Higher interest rates will put additional cash flow pressure on municipalities while they will also have less reliance on Federal support now that COVID-19 funding is going away. Additionally, municipalities must balance rising expenses with the prevalent resistance to increased state and local taxes. With rates at near zero for many years, the current rising rate environment is going to require more due diligence for investors in the municipal market.
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