How investors can beat the key risks of municipal bonds
Why investors should consider municipal bonds despite Puerto Rico (Part 7 of 8)
Key risks of municipal bonds
Municipal bonds (or munis) are issued by state and local governments and their agencies to fund capital expenditure on public projects (like highways, bridges, schools, or hospitals). In the last article of this series, we discussed some of the benefits of investing in municipal bonds (RVNU). In this part, we’ll discuss some of the risks inherent in municipal bond (VRD) investments.
Like all fixed income (LQD) investments, municipal bonds (PVI), too, carry credit risk and interest rate risk.
Credit risk for municipal bonds
“Credit risk” refers to the possibility of the borrower’s inability to pay interest and repay the principal amount of the debt in a timely and complete manner—the risk of the borrower defaulting on interest and principal commitments. While the default rate on municipal bonds (RVNU) has typically been lower than similarly rated corporate debt (HYG), it’s still there—especially for smaller and unrated issues. High-profile examples of municipal bond defaults include:
The bankruptcy of the city of Detroit in July 2013
The bankruptcy of the city of Harrisburg in October 2011
While the commonwealth of Puerto Rico hasn’t yet defaulted on its ~$70 billion debt (it can’t file for bankruptcy as per the prevailing rules), it was forced to issue ~$3.5 billion last month in GO junk bonds (a new record) to service its existing debt.
Don’t put all your eggs in one basket: Combating credit risk
Investors can reduce credit risk arising from municipal bonds through diversification. Diversification implies limiting risks to individual issuers by investing in bonds from multiple issuers. It may be difficult for retail investors to invest in multiple bond offerings (munis are usually issued in increments of $5,000). ETFs are a good option, as they provide liquidity, don’t usually have such stringent minimum investment norms, and also provide diversification benefits by exposure to multiple issuers.
How to leverage interest rate risk for increasing returns
“Interest rate risk” refers to fluctuations in the price of municipal bonds due to movements in interest rates. Bond prices and rates move in opposite directions, so an increase in interest rates lowers bond prices and vice versa. Investors can limit interest rate risk by lowering the duration of their bond portfolios, applying a bond laddering strategy or by simply holding the bond to maturity.
Alternatively, they can even benefit from rising rates by investing in Variable Rate Demand Obligations (or VRDOs). The Invesco PowerShares VRDO Tax Free Weekly Portfolio (PVI) and the State Street SPDR S&P VRDO Municipal Bond ETF (VRD) are two ETFs providing exposure to VRDOs. A detailed description of these ETFs is provided in Part 4.
Liquidity risk
This occurs if the bond buyer can’t offload his investment due to lack of a market in the security. This happens if the security is thinly traded (quite common for individual issues). Muni bond ETFs are more liquid and have a more active secondary market. Also, muni bond ETFs may also be impacted by liquidity risk of a different sort: mass withdrawals from ETFs by investors due to bad news (like Detroit’s default or Puerto Rico’s debt fears) would force fund managers to offload positions in an untimely manner to meet the funding needs.
Please read on to Part 8 of this series to find out whether investors should consider investments in municipal bonds or the ETFs that invest in munis.
Browse this series on Market Realist:
