As I point out in the article Investing in Municipal Bonds: Determining if Tax-Free Munis are Right for Your Portfolio, the average investor can experience significant tax savings by moving a portion of his or her portfolio into tax-free municipal bonds. In this article, we are going to discuss specific tests of safety that can help you determine which issues to purchase.
Type of municipal bond no guarantee of safety
Contrary to popular belief, general obligation bonds are no safer than revenue bonds. This misconception arises because the former is serviced by the issuer’s “unlimited” power to tax. In all reality, however, the power to tax is limited by practical considerations; a municipality that increased taxes to an onerous level would soon experience a mass exodus as citizens relocated to areas with more favorable characteristics. An investor would be far better off purchasing a high quality revenue bond than a mediocre general obligation bond (it is important that the investor remind himself that “in theory” is sometimes a dangerous game to play – I would much rather lend money to a farmer that paid his bills on time than a King with an empty treasury.)
Recommendation for the minimum size of municipality
It is not necessarily true that the larger a municipality, the stronger its obligations; yet, there is some advantage to size. Debt issues backed by large populations are more liquid. Although this need not concern an investor that plans on holding until maturity, those who think they may need or desire to sell several years down the road will find this advantageous. It was partially for this reason that Benjamin Graham recommended an investor only purchase municipal bonds issued by municipalities with populations of 10,000 or greater (see page 131 in Security Analysis, 1934 Edition and page 156 in Security Analysis, 1940 Edition.)
Credit ratings of general obligation bonds
The credit rating of a particular municipal bond is extremely important to the lay investor. Credit rating agencies determine the strength of a general obligation municipal bond issue by examining the economic environment of the area (i.e., the wealth level of the average household), the total amount of debt outstanding (e.g., a $10 million bond issue is not of concern for a huge city but may be a crushing burden to bear for a town of 500) and the diversification of industry (i.e., does the municipality depend upon a single industry such as Bethlehem, PA and the steel mills in the mid-twentieth century, or does it boast a diversified industrial and commercial base encompassing a wide spectrum of enterprise.) On the whole, general obligation bonds yield less than revenue bonds.
Credit ratings of revenue bonds
Likewise, the ratings of revenue bonds are determined by the total “debt service”, or how many times the cash specifically available to pay interest and principal payments on the company’s bond issues could cover those payments. A hospital that had $20 million available to service debt but had only $5 million in debt payments due that year would have a debt-service coverage ratio of 4 ($20 million divided by $5 million = 4.) A debt service coverage ratio of two is generally considered acceptable assuming the other tests of safety discussed have been met; the higher the debt service ratio, the safer the bond.
Municipal bond insurance
As many as fifty-percent (50%) of the municipal bonds issued today are insured. What does this mean? In exchange for a fee, firms that underwrite muni bond insurance make a legally binding promise to pay the interest and principal of a municipal bond if the issuer is unable to do so because of financial difficulty or catastrophe. Currently, there are four AAA-rated firms that insure municipal bonds; the Municipal Bond Insurance Association (MBIA), American Municipal Bond Assurance Company (AMBAC), Financial Guarantee Insurance Company (FGIC), and Financial Security Assurance (FSA). Because each of entities has the highest credit rating possible, the municipal bonds they insure are rated AAA as well.
Municipal bonds that would only qualify as border-line investment grade will often seek insurance in order to increase the issue’s credit rating and, as a result, lower the cost of borrowing. In other words, satisfied with the safety of the insurance company’s guarantee, investors are willing to accept a lower coupon rate because they believe there is less risk of default. Still, municipal bonds that are rated AAA because of their insurance protection will almost always yield more than an issue that would qualify for a triple-A rating on its own.
