In our previous chapters, we wrote an overview of muni bonds as well as the history of the municipal bond market. This is chapter three of a ten part guide on municipal bonds.

Municipal bonds provide investors with a chance to support their local communities while taking the opportunity to receive interest payments that are generally reliable and tax-free. For many, the greatest appeal of muni bonds is the calmness of being able to sleep at night knowing that they have made a sound investment that meets their personal needs. But as attractive as muni bonds may be for all these reasons, there are also some risks inherent in investing.

In this section we’ll cover some of the risks of muni bonds.

Lower Interest Rates and Yields

Municipal bonds are often seen as a more reliable investment than corporate bonds, with historically low default rates as compared to their corporate counterparts. The flipside of that reduced risk, however, is that muni bonds typically offer much lower interest rates and yields than corporate bonds. (Although note, after taxes, muni bonds might actually return higher rates but we’ll discuss the difference between these two concepts in an upcoming section.)

Over the past decade, the average yield on municipal bonds has been just over 4%. Corporate bonds, on the other hand, have averaged between 5 and 7%.

Here’s a general idea of how S&P-rated AAA muni bonds are paying these days:

  • 1.8-1.85% for bonds with a 10-year maturity
  • 2.5-2.65% for bonds with a 20-year maturity
  • 2.65-2.8% for bonds with a 30-year maturity

Notice that the longer the term of the bond, the higher the yield.

Since AAA is the highest credit rating a bond can attain, munis rated AAA will typically pay less than those with lower ratings, as the risk is much more limited.  We’ll review the bond ratings system in further detail later on in our series.

Here’s how S&P-rated A muni bonds are paying, by contrast:

  • 2.5-2.65% for bonds with a 10-year maturity
  • 3.25-3.4% for bonds with a 20-year maturity
  • 3.55-3.7% for bonds with a 30-year maturity

Bonds with higher interest rates also tend to come with more risk. Opting for a more attractive interest rate could mean putting yourself in a position where you may lose out on interest payments or principal down the line.

Investment Grade vs. Non-Investment Grade

Now when you compare interest rates, keep in mind that interest earned from corporate bonds is subject to federal taxation, whereas interest earned from munis is not. That said, there are plenty of scenarios in which you’ll come out ahead by choosing a corporate bond with a significantly higher yield and paying the taxes on your earnings. If you’re not particularly concerned about increasing your tax burden, it pays to crunch the numbers and see whether corporate bonds are a more attractive investment.

Not Completely Risk-Free

As relatively safe an investment as municipal bonds may be, they still carry many risks, including:

  • Defaults
  • Market fluctuations
  • Interest rate risk

Though defaults are rare, they can happen, even to bonds with high credit ratings.  In recent years, we’ve seen twice as many defaults as compared to previous years. Both 2010 and 2011 averaged 5.5 defaults per year — not a lot, but double the 2.7 per year average the market held in the 39 years prior. Of those defaults, the majority stemmed from revenue bonds, specifically the housing and healthcare sectors.

One thing to note with regard to risk is that municipal bonds may carry insurance in the event of a default. You can also protect yourself by reviewing the credit ratings of the bonds you’re interested in purchasing. Bonds rated below BBB- by S&P or Baa3 by Moody’s have a higher risk of default; anything higher is considered investment grade and is therefore typically a safer bet.

Even if you take the risk of a default out of the equation, you should still be aware that market fluctuation can impact the face value of your bonds at any given time. Let’s say you pay $10,000 for a particular bond with a 30-year term. You may want, or need, to sell that bond before it comes due, but if the market value at the time is only $8,000, you’ll lose money by unloading it.

Then there’s the risk of rising interest rates on a whole to consider. When you purchase a bond, you’re locked into that particular interest rate until the bond comes due or you choose to sell it, which, as we just discussed, could result in a loss of principal. The risk, therefore, stems from having your money locked in at a certain rate when new bonds with more attractive yields become available.

Hard to Find

Municipal bonds aren’t as widely available as corporate bonds, and as such, they’re often sold for more than what their face value is actually worth. This means you may have to pay a bit more to get your hands on your bonds of choice, as the limited supply of muni bonds helps brokers command significant markups. On top of paying more for your bonds, you may find yourself in a situation where you’re pressured to make a snap decision, as purchasing opportunities can quickly expire. And pulling the trigger without first doing your research can have negative consequences, as we’ve learned.

Bond Sale

Protecting Yourself From Muni Bond Losses

Clearly there are risks involved in investing in municipal bonds, but the more educated you are, the more you can do to protect yourself. Check the muni bond credit ratings and understand what each credit ratings mean before you buy is a good first step. Keep in mind that the credit ratings can change over time. If you’re serious about safeguarding your investments, you’ll need to commit to keeping tabs on them regularly. This means accessing your portfolio once a quarter to see how your bonds are faring, and staying abreast of financial news as it pertains not just to the bonds you own, but to the market in general. You will also want to ensure your portfolio is still appropriate for your financial and investment needs.

Another warning that most savvy investment advisors will give you is that past performance is no indication of future success. This means that even if a bond’s history is amazing, that doesn’t necessarily mean it will be going forward. Same goes with muni bonds.

Most importantly, each bond has its own risks that are listed in the issuing documentation. We encourage you to read the documentation before making any investments and when in doubt, consult with your financial advisor.

Benefits of Muni Bonds are Still Plenty!

This entire post discussed the risks of investing in municipal bonds. But did you know there are a handful of awesome benefits of muni bond investments? In other chapters, we’ll compare municipal bonds to corporate bonds, treasury bonds, and mutual bond funds to help you assess whether they fit your investment style.