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Fixed Income

Navigating the Municipal-Bond Minefield

By Roger S. Conrad, on Dec. 18, 2013

Well-heeled investors have pursued the first strategy for decades, though all too many have scant idea about the issuer’s financial health and the sources of cash flow that pay the interest on their holdings.

Any readers who own individual municipal bonds should know the following information about their holdings. If you have a broker or financial advisor managing this portion of your portfolio, make sure that he or she knows the answers to these questions.

  • Where does the cash supporting interest payments come from? The answer to this question starts with the identity of the issuing authority. But every bond is paid from a different source of cash flow, from bridge tolls to cigarette taxes.
     
  • How secure is the cash flow that supports the interest payments on the bond? In the case of a general obligation, the issuer’s overall health is of paramount importance. For bonds backed by revenue generated from specific assets or services, you’ll need to dig a bit deeper to get the facts. Credit ratings provide a decent guide to an issuer’s health, though these ratings don’t encapsulate every risk factor.
  • When do your bond holdings mature? In general, the sooner a bond is scheduled to be paid off, the less credit risk to your interest and principal. Bonds with shorter maturities also entail less exposure to inflation and interest rates.
  • Do your holdings include insured bonds? Many municipal bonds owe their high ratings to bond insurance–a financial product where insurers pledge to make investors whole in the event of a default. However, this system hasn’t been tested by a wave of simultaneous defaults, not even in 2008. Insured bonds usually command a premium to uninsured bonds. In these instances, you’re paying for insurance that’s never been tested and may not work in a real crisis.
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