There are two primary ways to purchase municipal bonds: buying bonds funds or buying individual bonds. While buying a fund is relatively straightforward in terms of analysis, deciding between individual bonds can be significantly more difficult given the many different factors at play. The bond’s yield and tax advantages are one consideration, but investors shouldn’t ignore the risk factors that could influence the bond’s cash flows over time.
In this article, MunicipalBonds.com takes a look at some common techniques to analyze the risks of both general obligation bonds and revenue bonds issued by municipalities.
General Obligation Bonds
General obligation bonds are the safest type of municipal bond since they are backed by a municipality’s ability to collect taxes and pay off interest and principal.
The most important factors to consider include:
- Tax Base: The total asset value and taxable values per capita of a municipality should be analyzed, as well as future taxation growth potential. For instance, a highly leveraged municipality with no growth potential may be a risky investment.
- Diversification: The diversification of a municipality’s economy is important in order to mitigate the risk of any industry-specific downturn. Obviously, Detroit’s reliance on the automotive industry turned out to be a big driver behind its weakness.
- Unfunded Liabilities: Unfunded liabilities like public pensions can sneak up on municipalities that aren’t properly budgeting. For instance, many of these liabilities have taken a toll on Puerto Rico’s ability to repay its debts.
Investors should also carefully consider the mechanics of the debt itself. For instance, school districts and county governments often have debt that overlaps cities or towns. A specific debt issuance may also be subordinate to another claim, which increases the risk in the event of a downturn that affects liquidity. And finally, bond issues in the pipeline that could affect the solvency of a municipality must also be considered when buying individual bonds.
Revenue Bonds
Revenue bonds are inherently riskier than general obligation bonds because they are financed purely by an individual project rather than from a taxable base.
The most important factors to consider include:
- Feasibility Study: The feasibility study outlines key factors involved with the project, including user tolls, fees, special taxes and other payments. For instance, a tollway may include revenue estimates that can be used to determine coverage ratios.
- Protective Covenants: Many revenue bonds have protective covenants in their indentures that require sinking funds, subordination of future debt, and recourse to physical assets in the event that the project defaults.
- Revenue Pledge: Revenue bonds often include cash flow information, including a revenue pledge that promises all future revenues will be used for debt service prior to any other expenses, which serves as a guarantee of sorts.
Investors should carefully read through these contracts before purchasing a revenue bond given the greater risk profile. In addition, investors can obtain a credit rating, commercial research, or other materials designed to support their decision. Credit enhancements may also be used if the issue is too risky, including bond insurance, federal credit programs, bank letters of credit, or state school guarantees.
The Bottom Line
Municipal bonds can be complicated to analyze with so many factors in play. After deciding whether to purchasing a general obligation or revenue bond, investors should consider the factors laid out in this article in order to reduce their risk of loss.
