Bonds are thought to be safe investments. Or, safer than stocks, at least. (How we measure risk is all subjective, so I will bow out of that conversation for now.)
Municipal bond defaults are rare, but they do happen. In this recent WSJ article they detail how an Arizona sports complex, that was partially funded by muni-bonds, went bankrupt about a year after opening. They pledged to pay back their $280 million in muni bonds with revenue from the facility rentals and 600+ seat bar. But things did not turn out as planned, and now the bonds are trading roughly at 10 cents on the dollar and the sports complex is looking for a new owner.
How can a 'safe' investment turn south so quickly?
First, let’s make we're on the same page about what muni-bonds are, and then we can talk about why we may buy them.
Muni bonds are bonds issued by local, county, and state governments, and some semi-governmental agencies. These bonds are attractive to investors primarily because the interest is usually tax-free. (Muni bond taxation is a deep topic by itself, so I’m keeping it simple and saying we’re buying 100% tax-free bonds.)
They are issued in one of two categories:
General Obligation bonds:
Bonds are issued to fund ongoing operations for the issuer.
Interest is a ‘general obligation’ of the issuer. As long as the issuer can collect taxes they will pay bond interest like any other expense.
Revenue bonds:
Bonds are issued to fund a specific project like sewers, toll roads, new stadiums or other infrastructure projects.
The interest is dependent upon the revenue and success or failure of the project.
The obvious difference here is the source of the interest payments. Revenue bonds carry more risk and therefore they offer a higher interest rate (remember: higher risk = higher reward). But as we just read these municipal bond projects can, and do, fail.
Your takeaway: don’t get too cute with your muni bonds.
We buy muni bonds for their tax-free interest. A lot of us get tempted to go for higher interest earning bonds…but as we see this strategy can backfire.
Personally I will only buy municipal bonds from issuers with long, dependable payment history.
If you’re stretching for more return, the place to do it is NOT by going more aggressive with your muni bonds. There are other tweaks you should make first that involve less risk.