The municipal bonds market has seen a number of cities default over the years, including Detroit’s default on $369 million worth of unlimited general obligation bonds in 2013. These defaults may have scared some investors, but the impact has proven to be both rare in occurrence and temporary in nature. Just two years later, Detroit returned to the muni bond market with a $245 million offering at a 4.5% yield and extra protections for bondholders.
In this article, we will take a look at why investors should consider U.S. city bonds and how to find bonds that are unlikely to experience problems down the road.
Reasons to Invest
General obligation bonds come in a variety of different flavors, including statewide bonds, county bonds, and city bonds. While statewide GO bonds may seem like the safer route due to their larger size, city bonds offer a number of unique advantages compared to these larger peers that investors may want to consider. And, only five of 12,000 city bonds rated by Moody’s have defaulted on GO bonds between 1970 and 2012.
Cities have greater flexibility when it comes to increasing taxes to pay down debt, while unlimited tax GO bonds take priority over other types of debt. In general, cities have much more stable tax revenue than states since they are financed with property tax and include federal support. Property taxes tend to react more slowly to the economy than sales and income taxes, while property assessments themselves tend to lag the economy.
The structure of debt for many cities is also more advantageous than state governments. Often times, city governments are required to operate a balanced budget that keeps liabilities at reasonable levels. Many city bonds are also structured like traditional loans that make interest payments and pay down a portion of the principal borrowed with every coupon payment rather than having to pay off a lump sum when the bond reaches maturity.
Finding City Bonds
There are many factors that come into play when analyzing and selecting city bonds to build out a diversified portfolio. While the bond’s credit rating is a good place to start, there have been some instances of default with relatively high credit ratings in the past. For example, Baldwin County, AL had a credit rating of A1 at the time of its default in 1988. Credit rating agencies have been a lot more conservative in recent years.
In addition to the credit rating, investors should look at both population demographics and the city’s economy when making their decision. Cities with stable or increasing populations are typically the safest options since they are indicative of a strong economy and an expanding taxpayer base. It’s also important to look at the key industries and companies involved in a particular city to ensure that the economy is sufficiently diversified.
Finally, investors should ensure that any city bond represents just a portion of an otherwise diversified portfolio. A bankruptcy in a single municipality should not have an oversized impact on an investor’s overall portfolio, while the incorporation of different asset classes can help mitigate risks that impact the entire muni bond asset class. Some investors may want to look towards exchange-traded funds (ETFs) as a way to easily achieve this diversification.
The Bottom Line
City bonds may seem riskier than other types of general obligation municipal bonds, but in reality, they offer a number of potential advantages. Investors may want to keep these advantages in mind when building a muni bond portfolio, while being sure to factor in both the bond’s credit rating and external factors like population demographics and the economy. And as always, it’s important to maintain a diversified portfolio to reduce overall risk.