The Risks of Municipal Bonds

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Municipal bonds typically offer an attractive yield advantage over U.S. Treasuries for investors in higher tax brackets, but how much are you paying 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 considering municipal bond investing. There is a relatively low rate of default risk, but interest rate risk and headline risk do exist.

Default Risk Is Low

Based on a study conducted by the fixed income rating agency Moody's, yields on municipal bonds sufficiently compensate investors for the additional risks. In the 42-year period ended with 2011, 100% of Aaa-rated municipal bonds delivered 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, only 0.8% of municipal bonds rated investment-grade defaulted within 10 years of issuance.

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.

However, even lower-rated municipal issuers have a relatively low incidence of default. From 1970 to 2011, 7.94% of below-investment-grade municipal bonds defaulted. (Aaa, Aa, and A are considered investment grade, while the remaining tiers are below-investment-grade, or high yield.)

While the default rates for the lowest-rated bonds (B and below) were above 20%, these lower-rated bonds only make up a small portion of the overall muni market.

Ratings for the Market

For the municipal bond market as a whole—both investment-grade and high yield—only 0.13% of all rated issues defaulted within 10 years in the interval from 1970 to 2011. In this period, there were just 71 defaults out of the 9,700 issues rated by Moody’s. The rate picked up somewhat in the sluggish economy of 2010–2011, with 5.5 defaults per year in this period compared with 2.7 per year from 1970–2009.

While municipal bonds certainly carry their share of risks, this is ample evidence that the likelihood of defaults in the municipal market is very low notwithstanding the various high-profile defaults that occurred in 2012 and 2013. The key takeaway: Investors in individual bonds can significantly reduce their exposure to default through a focus on higher-quality securities.

Reasons for the Low Default Rate

Keep in mind, the price of a defaulted bond does not necessarily go to zero—investors can typically expect some degree of recovery. In a 2009 study, the investment firm Asset Dedication offers the following summary of the likelihood of defaults in the municipal market:

“...there are a number of safeguards in the municipal bond market that reduce the likelihood of high default rates... Improved regulation, transparency, and oversight have brought more structure to the market. Bond insurance provides investors with an added layer of protection... In addition to the number of safeguards that help improve investors’ ability to evaluate municipal bonds, from a practical perspective, defaulting on bonds would essentially lock the issuer out of the market. Since the bond market is the best source of financing for municipalities, defaulting simply does not make sense.”

The Role of Interest Rate Risk

While default risk is low, municipal bonds are subject to interest rate risk, or the risk that rising rates will lead to falling prices. This is particularly 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 municipal bonds will follow suit. Investors will, therefore, see their principal value decline even if defaults remain low.

As a result, it's essential to make sure that the investment you choose is suitable for your time horizon, objectives, and risk tolerance. When assessing a fund, it pays to look carefully to see how the manager performed in down markets, what kind of track record he or she has, and the quality of the securities in which the fund is invested.

Headline Risk

Municipal bonds also face the risk of adverse headlines, such as when a high-profile default makes headlines. A prime example of headline risk occurred in late 2010 when analyst Meredith Whitney went on 60 Minutes and predicted that weakening economic conditions could lead to a “spate” of defaults among municipal issuers.

“You could see 50 sizable defaults, 50 to 100 sizable defaults, more,” Whitney said. “This will amount to hundreds of billions of dollars worth of defaults.”

This prediction frightened investors and drove the municipal market down nearly 6% in the weeks that followed. When the market finally bottomed two months later, the municipal market had lost almost 10% of its value from the time of the interview.

While such events can be concerning at the time they occur, municipal-bond market downturns related to headlines become attractive buying opportunities over time.

The Bottom Line

The risk that any individual municipal bond with a high credit rating will default is negligible, although anyone putting cash into an individual issue needs to do extensive research. While it is useful to know that defaults are rare, it's also important to keep in mind that other risk factors come into play.