What makes a municipal bond a safe investment?
In its bid to change from its agricultural roots and reinvent itself as a tony tourist destination, Stockton, Calif. issued several municipal bonds. The city incurred the debt to finance buildings like a marina and a stadium, expecting a payoff from its gamble. But it was not to be. Crashing real estate prices (which severely lowered income from property taxes) and high pension benefits for retired city workers greatly strained finances.
In 2012, Stockton filed for bankruptcy. It became the biggest city in U.S. history to default on its debts, a move that caused a ripple of concern among those who'd long believed city government bonds were a failsafe investment [source: Kristof].
Stockton isn't alone. Between 2010 and 2012, 31 local governments and city authorities (such as improvement districts) have declared bankruptcy. And that's only in the 22 states that allow municipalities to seek bankruptcy protection [source: Governing]. Despite the rash of defaults, they're still relatively rare -- about 0.3 percent annually [source: Kristof].
If you're planning to invest in municipal bonds, it pays to do some research. Here are some key details:
Check the record: Does the municipality have a history of paying on time? It's surprisingly easy to find out. Visit the Municipal Securities Rulemaking Board's Electronic Municipal Market Access portal.
Check the credit rating: What is the bond's credit rating? Look for bonds rated BBB or better by Standard & Poor or Fitch, or rated Baa or better by Moody. Even better, look for those that earn the highest rating from Moody (Aaa), Standard & Poor (AAA) or Fitch (AAA).
Check the call risk: A "call" means a bond can be redeemed (paid off) whenever the issuer decides, even if it hasn't reached maturity. This often happens when interest rates fall because it can save the issuer money. For investors, this means you run the risk of lost money, either in interest payments or capital. Most bonds, however, are non-callable [source: The Securities Industry and Financial Markets Association].
Author's Note: Just how safe are long-term municipal bonds?
I learned something surprising while researching this article, and that's how interesting municipal bonds can be. A new school under construction, a bridge being built, a state-of-the-art water treatment plant -- all of these things are happening around my community. And all are probably financed, at least in part, by municipal bonds. The idea of being able to make something possible, if only by being one of many individual lenders who buy into a bond, is one that appeals to me -- even if the project doesn't take place in my own backyard.
- Governing. "Bankrupt Cities, Municipalities List and Map." (Feb. 16, 2013) http://www.governing.com/gov-data/municipal-cities-counties-bankruptcies-and-defaults.html
- Investopedia. "General Obligation Bond." (Feb. 16, 2013) http://www.investopedia.com/terms/g/generalobligationbond.asp
- Investopedia. "Revenue Bond." (Feb. 16, 2013) http://www.investopedia.com/terms/r/revenuebond.asp
- Investopedia. "The Basics of Municipal Bonds." Aug. 5, 2012. (Feb. 16, 2013) http://www.investopedia.com/articles/bonds/05/022805.asp
- Kristof, Kathy. "Are Municipal Bonds Still Safe Investments?" Kiplinger. October 2012. (Feb. 16, 2013) http://www.kiplinger.com/article/investing/T052-C000-S002-are-municipal-bonds-still-safe-investments.html
- Kristof, Kathy. "How to Buy Muni Bonds Safely." Kiplinger. October 2012. (Feb. 16, 2013) http://www.kiplinger.com/article/investing/T052-C000-S002-how-to-buy-muni-bonds-safely.html
- Securities and Exchange Commission. "Municipal Bonds." (Feb. 15, 2013) http://www.sec.gov/answers/bondmun.htm
- The Securities Industry and Financial Markets Association. "How Safe Are Municipal Bonds?" (Feb. 16, 2013) http://www.investinginbonds.com/learnmore.asp?catid=8&subcatid=53&id=235