Municipal bonds - known as "munis" - are bonds issued by a state, territory, or possession of the United States or by any municipality, political subdivision, or authorized agency. "Munis" are extremely popular because the interest earned by the investor is usually exempt from state and federal taxes. However, the risks of investing in municipal bonds are often the most misunderstood investment instrument likely to end up in the portfolio of a typical investor. A bond is an obligation that must be repaid at a certain time, possibly in 10 or 20 years. In the interim, the borrower pays interest to the bondholder for the use of his or her money.
As recently as the early 1970s, most municipal bond buyers were banks, insurance companies, and other large institutions. But the municipal bond market is now dominated by tens of thousands of small investors, some of whom, as the result of mutual fund holdings, may not even be aware that their portfolios include municipal bonds. While small investors occupy an increasingly large share of the municipal bond market, few of these investors are aware of the high risks that may be associated with certain bond issues and the risks of default. Also, investors are apt to confuse the term "municipal bonds" with no-risk government bonds.
For more than 50 years, municipal securities have been specifically exempted from federal registration and review requirements. For example, in the absence of a prospectus delivery requirement, municipal bonds may be sold without revealing to investors the underlying financial health of the issuer of the bond, how bond proceeds will be raised and used, and the prices and dates at which the issuer can call back the bonds for early redemption.
Municipal bond issuers have undertaken some efforts at self-regulation. However, regulatory guidelines urging that an "official statement"--the municipal bond equivalent of a prospectus--be provided in all offerings are voluntary. Least likely to be accompanied by an "official statement" are those small, high-risk municipal bond issues likely to be purchased by small investors.
Ten steps to wise investing in municipal bonds
Think of yourself as a bank loan officer who wants all the information about a start-up business before making a decision about whether or not to grant a loan. Whether or not the municipal bond in which you are investing comes with an "official statement," you should take the time to get from the broker in writing the following details about the bond:
- A description of the securities offered for sale. Is this a general obligation (GO) bond or is the debt service dependent on income or taxes generated by the underlying entity?
- The issuer's authorizing and governing documents for the bond. Familiarize yourself with the details of the bond's purposes and how the issuing municipality or state plans to proceed with the offering.
- Complete description of the planned use of the bond proceeds. When will the bond be issued? What portion of the proceeds will be going to lawyers, financial consultants, and developers? Do these arrangements seem reasonable to you or your financial adviser?
- Guarantee provisions and other sources of possible payment for the securities. Who is left holding the bag if something goes wrong? Is the municipality or state responsible? If a third party (developer, underwriter, general partner, management company) is guaranteeing payment, is that party financially able to do so? Request audited financial statements if a third-party guarantee is involved.
- Any optional, mandatory, or extraordinary redemption or prepayment features. Under what circumstances, and on what timetable, can the bonds be called? Are these terms acceptable to you?
- Information about the issuer. Get all the information you need to develop a clear grasp of the intentions and quality of the government entity or corporation with whom you are doing business. In the case of private activity bonds, the investor should get information about the project developer, underwriter, trustee, project manager, and all other parties involved. Find out how and on what timeline the trustee will proceed in the event of a default.
- Information about the enterprise. If the bond is dependent on the success of either an underlying venture or related taxes, get a full reading on the likelihood of success and the risk of failure. Ask for information on comparable projects in other cities and states. Acquaint yourself with these parallel cases, but be on the lookout for unique circumstances which may not hold true in the case of your bond
- Pending legal proceedings. Will the bond be jeopardized in any way by pending lawsuits? Does the issuer or other involved party have any potential legal exposure of a significant nature? Do the relevant lawsuits indicate a pattern of conduct on the part of the issuer that may recur in the new bond offering? What contingency arrangements have the issuer or other parties made to handle a substantial financial loss in court?
- Debt structure of the issuer and issue. To what extent is the issuer authorized to incur debt? Are there limits on the amount that may be assumed? Ask for information on the issuer's overall debt trends. Frequently, this will be available from a chamber of commerce or economic development committee in the project community. Is the issuer overextended on bond offerings? If such information is available, what is the size of the issuer's projected debt burden over the next 10 or 25 years?
- The secondary market for the bond. Municipal bonds for very small projects have very small or "thinly traded" resale markets. A bond from a small issue may be very hard to resell at a price close to the original purchase price. Often, the only dealer who is willing to repurchase bonds from small issues is the dealer who sold it originally. Ask the selling dealer who makes a market in any bonds you buy. If only one dealer makes a market, you should be prepared to hold that bond until its maturity or accept a substantial discount from the purchase price if you try to resell it. Remember that it is always important to get all performance related claims in writing from a broker. Act only on those promises which a broker is willing to commit to paper. Oral statements and assurances may be difficult to firmly establish if things go wrong.