The Risks of Municipal Bonds

A woman checks her municipal bond investments.
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Municipal bonds often offer a good yield edge over U.S. Treasuries for investors in higher tax brackets. Still, how much will you pay in terms of risk to pick up the added yield? In short, there is not as much risk as you may think, but there is always some risk to be aware of when investing.

You should be aware of the risks if you are thinking about muni bond investing. There is a fairly low rate of default risk, but interest rate risk and headline risk do exist.

Headline Risk

Headline risk refers to the risk that comes from bad news going public. Municipal bonds face the risk of adverse headlines because high-profile defaults tend to make the news. A prime instance of headline risk occurred in late 2010. 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 drove the municipal market down nearly 6% in the weeks that followed. When the market finally hit its low two months later, the municipal market had lost almost 10% of its value from the time of the interview.

While such events can be scary at the time they occur, municipal-bond market downturns related to the news can create a good time to buy bonds when the tide changes.

Interest Rate Risk

While default risk is low, muni bonds are subject to interest rate risk, or the risk that rising rates will lead to falling prices. This is even more true for investors in bond funds and exchange-traded funds (ETFs) that invest in munis. If Treasury yields go up (meaning that prices are falling) it is very likely that muni bonds will follow suit. Investors will see their principal value decline even if defaults remain low.

As a result, it's vital to make sure that where you choose to invest is suited to your time frame, goals, and risk tolerance. When looking at a fund, it pays to take the time to find out how the manager of the fund did in down markets, what kind of track record they have and the nature of the securities in which the fund is invested.

Low Default Risk and Rate

Based on a study by the fixed income rating agency Moody's, yields on municipal bonds fairly compensate investors for the added risks. In the 42-year period ended with 2011, 100% of Aaa-rated muni bonds brought all of the expected interest and principal payments to investors.

In the same period, 99.9% of Aa-rated bonds did the same. The ratings come from Standard & Poor's general-purpose ratings. Aaa is the highest possible rating; Aa is the second-highest. Overall, .16% of muni bonds defaulted between 1970 and 2019, compared to 10.17% of global corporate bonds.

Higher-quality bonds tend to perform better than lower-rated securities even during times of economic distress. This is due to the underlying issuers keeping sufficient financial strength to keep making their payments even under adverse conditions.

Low Default Rate

Keep in mind that the price of a defaulted bond does not always go to zero. Investors can often expect some degree of recovery.

While muni bonds carry their share of risks, this is ample evidence that the chance of defaults in the muni market is very low. You can greatly reduce your risk of muni bond default through a focus on higher-quality securities.

Municipal bankruptcy or inability to pay bondholders, on the other hand, is a risk that has been around since 1970,

The Bottom Line

The risk that any single muni bond with a high credit rating will default is very low. Still, anyone putting cash into an individual issue needs to do a lot of research. While it is useful to know that defaults are rare, it's also vital to keep in mind that other risk factors come into play.