In this article, we will take a closer look at appropriation-backed muni bonds and whether or not investors should buy into them.

The Illinois Metro Pier & Exposition Authority municipal bond was downgraded by S&P from AAA to BBB+ on August 5, 2015 after failing to make a required monthly payment. While the state set aside money for the project, the funds could only be released with the state legislature’s approval on an annual basis. The legislature opted not to release the funds during the summer of 2015, which sparked the multi-notch downgrade on the bond and steep losses.

The Metro Pier & Exposition Authority bond is a classic example of an appropriation-backed muni bond. While general obligation bonds are backed by taxpayer dollars, appropriation-backed bonds depend on regular government approvals for repayment. Most annual appropriations are not legally binding and provide little in the way of recourse in the event that they’re not paid – leaving muni bondholders in a tough spot.

Many experts view state and local appropriation-backed bonds as generally providing inadequate yield compensation compared to the risks associated with the payment structure. Credit rating agencies typically assign appropriation-backed bonds ratings that are one or two notches below comparable general obligation bonds. These agencies have modified these rules in certain cases (e.g. California in 2012) but not nationwide.

The best way to avoid these problems is to stick to general obligation or revenue bonds that provide greater guarantees on repayment. While Puerto Rico’s debt crisis illustrates that there are no guarantees, general obligation bonds have an extremely low default rate and problems can often be observed well in advance. Revenue bonds are slightly riskier than general obligation bonds, but they are at least tied to semi-predictable revenue streams.

Investors who wish to purchase an appropriation-backed muni bond should carefully consider the issuer’s history of repayment and financial condition. In the case of Illinois in 2015, the state had clearly run into budget issues that it was struggling to resolve, although the bond was still rated AAA by S&P before the downgrade. Investors should be sure to do their own homework regarding a state’s financial health before investing in these kinds of bonds.

According to Ballotpedia, the states with the lowest credit rating include:

Municipal bond investors can further mitigate risk by diversifying across several states and types of bonds. Many exchange-traded funds (ETFs) focused on the muni bond sector provide this kind of diversification in a single equity that can be quickly bought and sold. While these funds have an expense ratio associated with them, investors may appreciate the lower upfront costs and added diversification associated with them.

Some popular muni bond ETFs include:

Investors can look at the prospectuses associated with these ETFs to identify the exposure to appropriation-backed muni bonds, as well as the exposure to states with low credit ratings.

Investors might assume that all bonds are legally binding contracts, but there are some exceptions to the rule. So-called appropriation-backed municipal bonds depend on annual approvals by state legislatures to release the funds for repayment. In some cases, bondholders have no legal recourse if the state fails to make these payments, which introduces a significant risk for bondholders that they may not have anticipated.

Since these bonds account for around 20% of the market, investors may be forced into holding some of these bonds, but they should at least be aware of the risks beforehand.