By Cooper J Howard
Given all the municipal bonds to choose from, how do you decide which ones should make up the core of your portfolio? With $3.6 trillion of muni debt outstanding1 spread among roughly 35,000 to 40,000,2 the choice may seem daunting, but we'll help you break it down.
Municipal bonds are sold by local and state governments to help fund public projects or municipal government operations, like building new schools or repairing city sewer systems. Their interest payments are usually exempt from federal income taxes and may be exempt from state income taxes if the bond issuer is located in the investor's home state. For these reasons, munis are often attractive to income-oriented investors looking to reduce income tax bills.
Munis can generally be classified into two camps-general obligation bonds and revenue bonds. General obligation, or GO, bonds are backed by the general revenue of the issuing municipality, while revenue bonds are supported by a specific revenue source, such as income from a toll road.
In this article, we'll focus on GO bonds. They account for 28% of the investment-grade muni market and are usually backed by the taxing authority of the bond issuer. Most states and local governments issue GO bonds to help fund operations or specific projects. The dollar value of GOs issued by states compared to local governments is roughly equal, even though there are fewer states than local governments. In other words, the amount of debt issued per state is much larger than the amount of debt issued per local government.
General obligation bonds make up about a quarter of the muni market
Source: Bloomberg Barclays Municipal Bond Index, as of 8/2/2019. "Other" includes insured and pre-refunded bonds.
The market's perception of GOs has changed
Although general obligation bonds account for only about a quarter of the muni bond market, they tend to get the most attention. Historically, GO bonds were considered the more secure of the two options, because they are backed by the full faith and credit of the municipal government. Given GO bonds' perceived security advantage, revenue bonds used to yield more than GO bonds on average - but that has changed in recent years, as illustrated in the chart below. The change can be partly attributed to Detroit's bankruptcy in 2013. Initially, Detroit tried to treat its GO bondholders as "unsecured" creditors,3 which would have gone against the market's longstanding belief of the security pledge of GOs. Detroit's bankruptcy was settled outside the court, so there was no legal opinion on its security pledge. The result was that muni market participants began to scrutinize GO bonds more closely.
Revenue bonds used to yield much more than GO bonds
Bloomberg Barclays Indices, as of 8/2/2019. Differences in yields may be attributable to certain features such as call maturities, durations, call features, average credit ratings, or other factors. Past performance is no guarantee of future results.
There are different types of general obligation bonds
A common mistake some municipal bond investors make is assuming that any general obligation bond issued by a state or local government is backed by the same pledge. Since the yield on the average GO bond has moved closer to the yield on the average revenue bond, it's especially important today to understand the different credit pledges on GO bonds. The most common types of GO bonds issued are:
GOs backed by a dedicated tax pledge as well as unlimited taxing authority
GOs backed by unlimited taxing authority, with no dedicated tax
GOs backed by limited taxing authority
These three types are listed in order from generally the strongest to the weakest, in terms of their financial pledges.
1. Unlimited tax GO, with dedicated tax
These bonds are often backed by a dedicated tax - usually property tax - that the municipality collects. Frequently, these bonds are also backed by a pledge that the issuer will use all other available revenue sources, such as other taxes or state support, if the taxes specifically authorized to repay the bonds aren't sufficient.
In California, for example, school districts often issue bonds backed by a property tax dedicated specifically to debt service on the bonds. Voters within the school district must agree to the tax, and the dedicated property tax cannot be mixed with the school's other revenues. If the school district doesn't have the necessary funds to pay the bonds, it typically must increase property taxes to meet the amount due. In our view, this is one of the strongest security pledges for municipal bonds.
2. Unlimited tax GO, with no dedicated tax
These bonds are backed by the general revenues of an issuer, including taxes. Unlike dedicated tax GOs, however, they do not have a specific tax pledged to repay them. Instead, bondholders are paid from general revenues, and if those prove insufficient to cover debt service, the issuer typically must raise taxes. In our view, this is a very strong pledge.
3. Limited tax GO
Like unlimited tax GOs, these bonds are backed by the general revenues of an issuer, including taxes. However, the issuer doesn't have the ability to increase taxes by an unlimited amount to pay the bonds back. The limit on the amount of tax increase allowed is generally described in the bond offering statement, and the bonds are clearly labeled. Although we believe this is still a strong pledge, the limit on the tax lessens the security of the bonds.
GO bonds tend to be highly rated and usually pay interest and principal on time
With high-profile cases like Detroit's bankruptcy and Puerto Rico's effective bankruptcy in 2017, it may seem like GOs frequently default - but that's not the case. As illustrated in the chart below, defaults are rare in the muni market and even rarer for general governments, which include GO bonds. The recent rise in defaults by general governments is the result of defaults by Puerto Rico and Detroit. Although state and local governments face headwinds, such as a potential slowdown in the economy and rising pension burdens, we think defaults among GOs will continue to be rare.
General governments, which include GO bonds, have rarely defaulted historically
Moody's Investors Service, as of 8/6/2019.
What investors can consider now
Given the potential for a slowdown in the U.S. economy and stresses on some municipal governments, we think it's especially important today to know what is backing your municipal bond and how to combine different muni bond types to build a well-diversified portfolio.
General obligation bonds, in combination with other essential service revenue bonds, can serve as the core of a muni portfolio. First, focus on higher rated issuers - those rated AA-/Aa3 or above. More speculative investors looking for higher interest income could consider no more than 30% in lower rated issuers - those rated between BBB-/Baa3 and A+/A1. As one would expect, a lower-rated bond has a much greater chance of default than one with higher ratings.
1 Bloomberg, as of 8/5/2019.
2 Municipal Market Analytics, as of 4/29/2019.
3 City of Detroit Proposal for Creditors, as of 6/14/2019.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.