As we enter the fourth quarter of 2009, investors are once again making trading moves with some confidence. The stock market has recovered substantially, at least as measured by the various stock market indexes, such as the Dow Jones and S&P500. Even so, smart investors have not forgotten the lessons of 2008 and 2009. Diversification is as important as ever, and muni bonds can be an important part of building a portfolio with lower risk.
Municipal bonds have historically had a much lower default risk than corporate bonds. They also can generate tax-free income. General Obligation municipal bonds have had even lower default rates. General obligation munis are those backed by the full taxing and spending authority of the government that issues them.
For example, general obligation California muni bonds are backed by the full taxing and spending authority of the State of California. Thus, California is both legally able, and obligated to spend as much revenue as it has to pay the interest and principal on its muni bonds. Theoretically, a government’s ability to repay its general obligation bonds is limited only by its ability to collect taxes.
As such, general obligation bonds are considered safer than other muni bonds that are tied to specific taxes or revenue streams such as airport bonds, highway bonds - including toll road bonds, and bonds issued by specific government agencies or divisions. Since these bonds can only be repaid using their predefined revenue streams such as tolls or airport fees, it is possible that the income would not be sufficient to repay the issued bonds.
Finally, many municipal bonds are insured. The repayment of these municipal bonds is guaranteed by an insurer should the state, city, or county be unable to repay the bonds with their own revenues.
The biggest concern in the municipal bond market for 2009 was the State of California and its budget crisis which threatened to imperil the repayment of billions of dollars of California Municipal bonds. Things were at their worst when the state started issuing IOUs to various organizations.
However, a recent budget solution appears to have made the situation better, at least for now. And, with the economy showing signs of improving, along with billions of dollars of Federal stimulus money flowing into the States, it appears that the muni bond market should finish 2009 in no worse shape than normal. That is, the systemic risk facing the muni bond market appears to have lessened and what remains is the typical risk associated with each individual issue.
Unfortunately, with the banking crisis of 2008 having laid bare the inherent conflicts of interest with the bond rating companies, and their inability to adequately grade complex financial securities, investors should be very careful before blindly accepting a AA rating from the big three.