The city of Detroit emerged from bankruptcy in 2014. Still, its previous inability to pay investors left some questioning their long-held assumption about the relative safety of municipal bonds.¹ Without question, in the wake of Detroit’s troubles, gaining a better understanding of municipal bonds makes more sense than ever.²
At their most basic level, there are two types of municipal bonds:
General obligation bonds, which are a promise by the issuer to levy taxes sufficient to make full and timely payments to investors, and
Revenue bonds, which are bonds whose interest and principal are backed by the revenues of the project that the bonds are funding.
Types of Risk
Both general obligation and revenue bonds share certain investment risks, including, but not limited to, market risk (the risk that prices will fluctuate), credit risk (the possibility that the issuer will not be able to make payments), liquidity risk (muni markets may be illiquid and result in depressed sales prices), and inflation risk (the risk that inflation may erode the purchasing power of principal and interest payments). They also may share call risk, the risk that a bond may be redeemed prior to maturity.
Revenue bonds are considered riskier than general obligation bonds since they are only obligated to make repayments to the extent that the project funded by the bond generates the necessary revenue to meet payment obligations.
Investors seeking to manage their risk may want to consider investing in general obligation bonds with investment-grade ratings.
Bonds used to support essential services, such as water or sewage, are also considered less risky since these services are normally unaffected by economic conditions that may impact other revenue bonds, such as private activity "munis," which fund projects by private businesses or nongovernmental borrowers.
Because the financial health of any one municipality cannot be guaranteed, diversification may help counter some of the risk involved.³
Since municipal bonds generally are sold in increments of $5,000 and may be subject to disadvantageous pricing for smaller investors, many individuals look to mutual funds to manage their municipal bond portfolio, since they offer the diversification, research, analysis and buying power that most individuals can’t match.