Joseph G. Mowrer III, The Daily Record Newswire
For more than 200 years, municipal bonds have provided states and local governments a means to finance public projects, while providing investors in these bonds safety of principal and interest. These bonds have historically been perceived as a safe haven for investors as they have weathered several economic storms over the decades.
With the most recent economic downturn, however, investors have become uneasy about the safety of all of their investments — including municipal bonds. But these investors should rest easy knowing their investment is safe from widespread defaults. Here are a few points investors should know about municipal bonds that may help them sleep at night:
• Municipal bonds provide essential services — water, sewers, utilities, hospitals and roads. These are basic needs of a community and a top priority for payment.
• Municipal bond defaults are very rare. From 1970 through 2011, the cumulative default rate for investment grade municipals is a miniscule .08 percent. These bond defaults are generally the result of a specific project failure, poor planning, or irresponsible behavior by a local government. These are in no way representative of the broad market.
• All states (with the exception of Vermont) have a legal requirement to balance their annual budget. (i.e. unlike the federal government, states cannot issue more debt than their budget allows).
• The average debt service ratio (total payments of principal and interest/total revenue) for all 50 states is only around 8 percent. Massachusetts, which has the highest ratio, allocates only 14 percent of the budget to debt service. (Source: American Legislative Exchange Council “ALEX,” 2012) This means the remaining 86 percent is where states will first look to trim expenses to ensure bondholders are paid. And in most cases, states are required by their constitutions to pay bondholders ahead of other creditors.
• States have received a wake-up call regarding their finances and have taken action to address some of their fiscal problems. They have been issuing less debt, refinancing existing debt at lower rates, and cutting costs. They are also addressing their pension and healthcare shortfalls by taking the necessary steps of reducing benefits to public employees and creating a more fiscally responsible path going forward. Their actions offer bondholders protection for the future.
While a diversified portfolio of municipal bonds should provide safety from credit risk, there are certainly other risks involved that should be considered.
As any bond investor knows, interest rate risk should be a primary concern. No one knows which way interest rates are headed, but we do know that even a small upward move in interest rates can have a dramatic negative impact on especially longer duration bonds. To illustrate this impact, we have watched the yield on a 30-year Treasury bond increase from 2.46 percent to 2.96 percent in the past 3 weeks — a large move in a short period of time. The resulting price decrease of this bond was over 8 percent.
In addition to interest rate risk, municipal bonds have the added risk of unknown future tax rates and unknown treatment of municipal income going forward. We know that municipal bonds should react positively to increases in tax rates (expiration of Bush tax cuts), since the tax-free feature becomes more valuable.
But as Washington looks for ways to increase tax revenue, there are ongoing discussions about placing a tax on some portion of municipal bond income, which would likely cause a negative reaction to municipal bond prices. It is difficult to assess how much, if any, of this uncertainty is already being factored into municipal bond prices.
Municipal bonds can still be viewed as a safe place for investors seeking safety of principal and tax-free income. As always, investors are urged to assess the risks and benefits and how they apply to their long-term goals to determine their allocation to municipal bonds.
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Joseph G. Mowrer III is an analyst/portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
