What you don't know about muni bonds could hurt you

When you hear the term "municipal bonds," what comes to mind? If you are like most people, you'll think, "safe."

That's exactly what two particular investors believed. After years of working and saving, this couple took more than $2 million in hard-earned savings to a national bank and requested that their funds be invested in "safe" bonds. They were put into a variety of municipal issues and funds and thought they were set for a comfortable ride in their golden years.

General obligation bonds are paid from "ad valorem" property taxes. When bonds are issued for improvements, property taxes can be raised to cover the debt payments.
Susana Gonzalez | Bloomberg | Getty Images
General obligation bonds are paid from "ad valorem" property taxes. When bonds are issued for improvements, property taxes can be raised to cover the debt payments.

Then the financial crisis hit. The couple's portfolio bottomed to about $1 million. It turns out their municipal bonds weren't so safe, after all, and what they didn't know about municipal bonds really hurt them.

To avoid a similar mistake, it's important to be aware of some key factors. First, when you invest in a municipal bond, your primary concern should be the issuer's ability to meet its financial obligations.

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Understanding the muni sectors is key. States, counties and other local governments or their agencies issue municipal bonds. Like all bonds, "munis" are loans for a specified period of time that pay interest along the way. At the end of the loan period, if all goes well, you will get your principal back. But where do the funds come from to pay back that principal? Broadly speaking, municipal bonds come in two flavors: revenue and general obligation.

Revenue bonds are issues backed by a specific stream of revenue. They come in many shapes and sizes but can be separated into two main categories: essential purpose and non-essential service.

"To be truly 'safe,' even among similarly rated municipal bonds, keep a close eye on the funded status of pension obligations and also consider the size of the municipality."

Essential purpose revenue bonds are issued for projects that have a very steady and predictable income stream, such as water and sewer systems. Non-essential service revenue bonds are issued for projects that have a much less predictable income stream. These include a wide variety of projects, from new golf courses to hospitals.

With general obligation bonds, a governing entity provides a full-faith and credit pledge to bondholders. This means a municipality pledges any legally available funds and taxing power for debt service payments. Typically, general obligation bonds are paid from "ad valorem" property taxes. A classic example involves bonds issued for improvements to a local school district. A local government can raise property taxes if it needs to increase revenue to cover debt payments.

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It's also important to know that corporate or municipal bonds are "rated" by rating agencies. As with grades in school, bonds rated with the letter "A" are considered better quality than those rated with the letter "B." But, just as two teachers may have differing standards for what constitutes an "A," so, too, do the rating agencies.

For example, the state of Connecticut is currently AA-rated. But the ratio of state pension liabilities to revenue is much higher than it is for other states with similar ratings. Additionally, smaller municipalities may find it more difficult than larger ones to make up revenue short-falls.

To be truly "safe," even among similarly rated municipal bonds, keep a close eye on the funded status of pension obligations and also consider the size of the municipality.

Do you understand markups and liquidity? People have told me their advisor is managing their bond portfolio for "free." However, the first lesson in economics is that there is no free lunch (except perhaps for diversification), and this is true for your bond portfolio, as well.

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On the corporate side of the bond market, issues trade frequently enough that it's harder to find meaningful markups. On the municipal side, markups (a premium a purchaser pays above the price at which a middleman acquired the issue from a seller) can easily be in the 1 percent to 3 percent range.

This means that the institution selling you the bond is pocketing what essentially amounts to a 1 percent to 3 percent fee on your bond. You have to actually look for these charges, because the markup is built into the price and shows up as a lower yield.

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Unlike equity markets, pricing in the bond market is much more subjective. Let's suppose you have an issue with a solid credit rating but you need to sell it on a low-volume day, such as the day before a holiday. You may have a great issue on your hands, but if trading is light, you may pay a steep penalty for liquidity.

If you have existing individual municipal bonds in your portfolio, ask your advisor to do a markup analysis to discover what you paid for them. Deal with liquidity concerns by implementing a well-thought-out financial plan that allows you to fully benefit from a laddered strategy. That way, you won't have to tap into an issue unexpectedly.

If your goal in owning municipal bonds is lower volatility and capital preservation, considering these three factors will help you increase your portfolio's level of safety.

—By Manisha Thakor, director of Wealth Strategies for Women at Buckingham and The BAM Alliance