Tests of Safety for Tax-Free Municipal Bonds

Lowering the Risk of Loss When Investing in Tax-Free Municipal Bonds

Tests of Safety for Investing in Tax-Free Municipal Bonds
If you want to sleep better at night, one risk management strategy is to apply rigorous quantitative and qualitative standards to your tax-free municipal bonds on a case-by-case basis before adding them to your portfolio. Additionally, you should revisit your bonds from time to time and see if they still hold up or if conditions have changed to the point it makes sense to sell and buy something safer. photovideostock / E+ / Getty Images

You already know that investing in municipal bonds is not only good for your portfolio, it's also great for society in many cases.  On top of this, as​ pointed out in the article Investing in Municipal Bonds: Determining if Tax-Free Munis are Right for Your Portfolio, the average investor can experience significant tax savings by moving a portion of his or her portfolio into tax-free municipal bonds, which are exempt from the reach of the Federal and, in some cases, state, governments as long as everything is arranged properly.

 In this article, we are going to discuss specific tests of safety that can help you determine which municipal bonds to purchase; ways to spot potential red flags that might indicate a bond is less than suitable for your net worth or might be in trouble of default.

Recognize That The Type of Municipal Bond Is Not, In and Of Itself, a Guarantee of Safety

Contrary to popular belief, general obligation municipal bonds are no safer than revenue municipal bonds. This misconception arises because the former is serviced by the issuer’s “unlimited” power to tax. In reality, the power to tax is limited by practical considerations; a municipality that increased taxes to an onerous level would soon experience a mass exodus as citizens relocated to areas with more favorable characteristics.  An investor would be far better off purchasing a high-quality revenue municipal bond than a mediocre general obligation municipal bond.

 (It is important that the investor reminds himself “in theory” is sometimes a dangerous game to play.  What counts is the specific bond indenture in front of you.  I would much rather lend money to a farmer who paid his bills on time than a King with an empty treasury.)

Establish Minimum Municipality Population Requirements for the Municipal Bonds You Add to Your Investment Portfolio

It is not necessarily true that the larger a municipality, the stronger its obligations.

 Nevertheless, there is unquestionably some advantage to size. Debt issues backed by large populations are more liquid. Although this need not concern an investor that plans on holding until maturity, those who think they may need or desire to sell several years down the road will find this a nice perk. It was partially for this reason that Benjamin Graham recommended an investor only purchase municipal bonds issued by municipalities with populations of 10,000 or greater (see page 131 in Security Analysis, 1934 Edition and page 156 in Security Analysis, 1940 Edition.)

Be Sure to Check the Credit Ratings of General Obligation Municipal Bonds

The credit rating of a particular municipal bond is extremely important to the lay investor. Credit rating agencies determine the strength of a general obligation municipal bond issue by examining the economic environment of the area (e.g., the wealth level of the median household, reliance upon a handful of key employers), the total amount of debt outstanding (e.g., a $10 million bond issue is not of concern for a huge city but may be a crushing burden for a town of 500 working class families) and the diversification of industry (i.e., does the municipality depend upon a single industry such as Bethlehem, PA and the steel mills in the mid-twentieth century, or does it boast a diversified industrial and commercial base encompassing a wide spectrum of enterprise?).

Remember that, on the whole, general obligation municipal bonds yield less than revenue bonds of comparable credit quality.

Be Sure to Check the Credit Ratings of Revenue Municipal Bonds

Likewise, the ratings of revenue municipal bonds are determined by the total “debt service”, or how many times the cash specifically available to pay interest and principal payments on the company’s bond issues could cover those payments. A hospital that had $20 million available to service debt but had only $5 million in debt payments due that year would have a debt-service coverage ratio of 4 ($20 million divided by $5 million = 4.) A debt service coverage ratio of two is generally considered acceptable assuming the other tests of safety discussed have been met; the higher the debt service ratio, the safer the bond.

 As an inverse of the prior established rule, remember that on the whole, revenue municipal bonds yield more than general obligation municipal bonds of comparable credit quality.

Examine Whether the Bond Is Backed By Municipal Bond Insurance and Whether the Bond Insurer Has the Capacity and Willingness to Promptly Pay Claims Under a Distressed Scenario

As many as half of the municipal bonds issued today are insured. What does this mean? In exchange for an insurance premium, firms that underwrite municipal bond insurance make a legally-binding promise to pay the interest and principal of a municipal bond if the issuer is unable to do so because of financial difficulty or catastrophe. For a long time, there were four AAA-rated firms that insure municipal bonds; the Municipal Bond Insurance Association (MBIA), American Municipal Bond Assurance Company (AMBAC), Financial Guarantee Insurance Company (FGIC), and Financial Security Assurance (FSA). Because each of entities has the highest credit rating possible, the municipal bonds they insure are rated AAA as well.  Legendary holding company Berkshire Hathaway once, and briefly, entered the municipal bond insurance underwriting field but retreated after finding pricing irrationally low, legendary investor Warren Buffett warning that some of the firms making promises were piling time bombs onto their own balance sheet and not getting paid sufficiently to justify the risk.

Municipal bonds that would only qualify as borderline investment grade will often seek insurance in order to increase the issue’s credit rating and, as a result, lower the cost of borrowing. In other words, satisfied with the safety of the insurance company’s guarantee, investors are willing to accept a lower coupon rate because they believe there is less risk of default. Still, municipal bonds that are rated AAA because of their insurance protection will almost always yield more than an issue that would qualify for a triple-A rating on its own.

Annette Thau, former Chase Manhattan bond analyst and author of the bestselling, "The Bond Book", offers the following additional caveats when analyzing tax-free municipal bonds.  Note that she abbreviates "general obligation" tax-free municipal bonds as "GO".

“Among GO’s, the weakest credits are found in two groups: GOs of large cities with deteriorating downtown cores and large social outlays, and older, small cities or districts with shrinking populations, a shrinking tax base, and deteriorating economics. Among revenue bonds, the riskiest bonds have been hospitals with a strong dependence on government reimbursement (government programs do not cover hospital expenses in full), bonds issued by developers of nursing homes (many of these are highly speculative), and so-called private purpose bonds (also called industrial development bonds, or IDBs). These are issued by specially constituted authorities on behalf of private businesses.”

Summary of Basic Requirements for Municipal Bond Safety

  • The municipality must have a minimum population of 10,000 residents
  • The municipality must not have a deteriorating downtown, shrinking population, shrinking tax base or deteriorating economics
  • The bonds of the municipality must be rated investment grade or higher by each of the various credit rating agencies.
  • Revenue bonds must have a debt service coverage ratio of at least two (2), preferably higher.
  • The municipal bond issue should carry insurance, especially if dependent upon relatively less stable sources of revenue such as a hospital.
  • The municipal bond issue should enjoy relative liquidity unless the investor plans (and is financially able) to hold until maturity.