What is a municipal bond?
A municipal bond is a form of debt obligation that is issued by a government entity, typically to fund capital projects such as building highways and infrastructure, etc.. When an individual purchases a municipal bond, they are effectively lending money to the issuer and in exchange receiving an agreed number of interest payments over a set period. Once this period comes to an end, the bond reaches maturity, and the bond holder receives a payment equal to the value of their original investment.
There are a number of risks associated with municipal bonds including call provisions which allow the issuer to redeem the bond early, prior to the date of maturity. This may occur when interest rates fall. Investors may lose income and, when the bond is reinvested by the issuer, the bond may then have a lower return.
Alarm bells
Just recently there have been a number of warnings issued regarding certain state and local government bonds. There are concerns that some may actually be laden with risk, meaning that they are far from being the wealth-preserving and income-generating investments they are usually assumed to be. As of October 2019, 108 borrowers who raised cash in the $3.8 trillion municipal market have faced a number of financial difficulties; they have missed debt payments or violated other terms of their bond contracts. This is the highest rate of violations in the last four years and represents a 30% increase from 2018.**
These figures were published by Municipal Market Analytics (MMA) and add to concerns that investment from yield-hungry investors is heightening the dangers of an already challenging market.
According to MMA around 41% of those facing difficulties sold the debt within the last three years. This is way above the historical average and also comes at a time when there has been a surge in impairments. **
“That impairments are rising faster than defaults means that defaults will continue to rise into next year as troubled credit begins to transition to defaults,” an MMA spokesperson told Bloomberg.**
The spokesperson added that the current appetite for risk is “incredible” and, as riskier bonds come to market, it is this factor which is driving the trend of problems occurring faster than usual.
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* https://www.irs.gov/individuals/international-taxpayers/characterization-of-income-of-nonresident-aliens Accessed 15-10-19
** https://www.bloomberg.com/news/articles/2019-10-08/warning-signs-flash-for-muni-bondbuyers-chasing-riskiest-debt?srnd=fixed-income Accessed 15-10-19
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