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Understanding the Role of Municipal Bonds in Your Portfolio and Potential Risks
Understanding the Role of Municipal Bonds in Your Portfolio and Potential Risks
Investment%20risks Municipal Bonds Risk Management
Municipal debt instruments have always played a crucial role in the overall composition of investor portfolios. Many investors gravitate toward muni debt instruments for their triple tax-exempt status (federal, state and local) and knowing that these securities are often backed by strong tax revenue streams.
Municipal issuers often exercise the call option on their high-coupon paying outstanding debt in a low interest rate environment; which essentially means that they can retire their outstanding bonds before maturity by either buying back or refunding it with lower coupon debt.
This poses a significant risk for investors whose debt has been retired by the issuer.
My take on this risk is almost exactly the opposite.
If I buy a bond at a high premium (i.e. richly priced because its coupon is well above market rates), I buy it expecting it to be called. (Regardless, one should always look at yield to worst, not yield to maturity, when buying bonds.) Because the coupon is well above market rate, my expectation that it will be called is reasonable. Even if rates rise a bit by the time the bond is callable, it should still be trading at a premium. That makes it close to certain that the bond will be called.
The risk is not that the bond will be called - that's anticipated - but that it won't. That can happen for at least a couple of reasons. One is that the issuer's financial situation has deteriorated so much that it can't issue new bonds to raise the cash to retire the old bonds. Which means my bonds have become more likely to default.
Another reason the bond might not get called is that we hit a period of high inflation, so even the high coupon I'm getting isn't enough to compensate. In that case, I'm stuck with this longer term fixed income bond in a high inflation environment. Again, not good.
Comments
If I buy a bond at a high premium (i.e. richly priced because its coupon is well above market rates), I buy it expecting it to be called. (Regardless, one should always look at yield to worst, not yield to maturity, when buying bonds.) Because the coupon is well above market rate, my expectation that it will be called is reasonable. Even if rates rise a bit by the time the bond is callable, it should still be trading at a premium. That makes it close to certain that the bond will be called.
The risk is not that the bond will be called - that's anticipated - but that it won't. That can happen for at least a couple of reasons. One is that the issuer's financial situation has deteriorated so much that it can't issue new bonds to raise the cash to retire the old bonds. Which means my bonds have become more likely to default.
Another reason the bond might not get called is that we hit a period of high inflation, so even the high coupon I'm getting isn't enough to compensate. In that case, I'm stuck with this longer term fixed income bond in a high inflation environment. Again, not good.