Municipal bonds are debt obligations issued by public entities that use the loans to fund public projects such as the construction of schools, hospitals, and highways. In general, the interest you earn from your tax-exempt municipal securities is exempt from federal income tax and, in some cases, state or local income tax, depending on whether you are a resident of the state that issued the bond.
While municipal bonds’ coupons are typically lower than those offered by similarly rated corporate bonds, the fact that interest income is tax-free can result in the yields being even higher in some cases on an after-tax basis. Corporate bond coupons are typically taxed as ordinary income.
A lot of municipal credit risks were exposed when the financial crisis hit in 2008, with municipal insurance companies failing, merging, or getting downgraded. This brought scrutiny to the municipal market as some investors began to question the safety of muni bonds. It’s important, however, to remember that not all municipal bonds carry the same amount of risk. The market, after all, offers a variety of types and legal pledges.
There are two main types of municipal bonds: general obligation and revenue bonds.
General obligation bonds carry the full faith and credit of the issuing municipality and are typically paid through property taxes.
Revenue bonds, which cover sectors such as water, sewer, and education, are funded by the revenues of that specific project and typically do not carry the full-faith backing of the municipality.
With revenue bonds, certain projects are more essential than others. Projects like water and sewer systems or public university improvements are considered essential in purpose. No matter the state of the economy or project itself, a municipality cannot afford to default on these types of programs because they are vital services for a community. However, projects such as housing and health care systems tend to have limited purposes and recourses and are generally not viewed as being essential services. Therefore, municipalities are much more likely not to intervene when these projects become insolvent.
This is shown in the default table below. As you can see, housing and health care projects make up the vast majority of municipal defaults over the past 40-plus years. Defaults in general obligation and essential service revenue bonds remain rare occurrences, as evidenced by the default statistics for education, cities/counties/states, and infrastructure projects.
Municipal Default by Sector, 1970–2018
# of Defaults
# of Defaults
Hospitals / Health Providers
Bottom line: We don’t believe in taking risks with bonds / fixed income. Bonds are primarily a portfolio ballast first and a source of income secondarily. We focus on high-credit-quality general obligation and essential service revenue bonds, such as water/sewer, university revenue and highway/transportation. These sectors have historically shown low-default rates. On the other hand, we strictly avoid unstable sectors such as health care, housing and industrial development.
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this blog is for general information only and is not intended to serve as specific financial, accounting, or tax advice. To be distributed only by a Registered Investment Advisor firm. © 2020 Buckingham Strategic Partners.
This blog is for informational purposes only. It should not be retransmitted in any form without the express written consent of Delap Wealth Advisory, LLC, an investment advisor registered with the United States Securities & Exchange Commission. The contents of this communication should not be construed as investment advice intended for any particular individual or group of individuals. All information, statements, comments, and opinions contained in this blog regarding the securities markets or other financial matters is obtained (or based upon information obtained) from sources which we believe to be reliable and accurate. However, we do not warrant or guarantee the timeliness, completeness, or accuracy of any information or opinions presented herein. Any historical price or value is as of the date indicated. Information is provided as of the date of this material only and is subject to change without notice.
Investing in securities involves the risk of loss, including the risk of loss of principal, which clients should be prepared to bear. No assurance is given that the investment objectives of any investment described in this communication will be achieved. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. The information contained in this blog is not intended as tax or legal advice, and Delap Wealth Advisory, LLC, does not provide any tax or legal advice to clients. You should consult with our firm or other independent financial, legal, and/or tax advisors before considering any investment or participation in any investment program.