The Hidden Risk In Municipal Bonds

Updated on

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

Investors generally regard municipal bonds as one of the safest investments – only Treasury bonds are less risky. But many of those bonds carry hidden risks. A proposed new SEC rule change will go a long way toward making investors aware of those risks.

Being a long-time municipal bond investor and advisor I have a framework of how a municipal bond should work. In essence it is quite simple. A community or one of its representatives decide that an essential service or facility needs development. They agree that if the community were to borrow funds to improve the sewers, schools, municipal buildings, sources of energy or other essential necessities could be created sooner. The people in charge – the politicians who represent the community –find an underwriter and financial advisor who will help them craft the borrowing. The bond issue is then sold to the public, including insurance companies, fund companies, advisors and individuals.

A general obligation bond is a bond backed by the full faith, credit and ad valorem taxes of the borrower. A revenue bond is backed by a stream of revenue for the life of the security. In exchange for buying the bonds, the purchaser will receive a stream of income – interest paid semi-annually – for the life of the bond. The bonds might have a call date, when the borrower call the bonds away, usually at 10-years – and a fixed maturity date.

The issuer receives the funds and the bond holder receives the interest and principal at maturity. This amounts to a clean deal and a method whereby investors can plan to pay for their children’s education and envision a retirement with funding in place.

Unfortunately bonds are long-term investments and politicians are very short-term. They know they need to be re-elected and put the political issues before the long-term needs of the community. Politicians may have the skills to be elected, but not other necessary skills to run a fiscally sound government.

What you don’t know won’t hurt you – really?

Under SEC Rule 15c2-12, issuers of municipal bonds are required to disclose events that might impact an investment in their bonds.[i] However, issuers are entitled to decide if the event is “material” or significant enough to require reporting. Investors are told that they should look at the material events before purchasing a bond and continue to monitor them to evaluate current holdings. However, the recent push by the Securities and Exchange Commission (SEC) to add protections for investors makes it clear just how much investors and industry participants are kept in the dark.

Currently, issuers must post an event through the Electronic Municipal Market Access (EMMA), according to the Municipal Securities Rulemaking Board (MSRB). An event must be disclosed, if material, under the SEC rule.

These events include the following, if material:

  • Principal and interest payment delinquencies and non-payment related defaults
  • Unscheduled draws on debt and credit service reserves reflecting financial difficulties
  • Substitution of credit or liquidity providers, or their failure to perform
  • Adverse tax opinions or events affecting the tax-exempt status of the security
  • Modifications to rights of securities holders and/or bond calls
  • Defeasances
  • Release, substitution, or sale of property securing repayment of the securities
  • Rating changes
  • Financial reporting
  • Bankruptcy

The issuer has the right to decide if any of these actions are “material.”

What do investors see when they review material events? They see rating changes, notice whether financial statements have been timely filed and a record of any bond calls.

But when a municipality is having problems, they generally fail to file their financials. There is no clarification as to the problems causing the failure to file. Investors are unaware of those problems.

By Hildy Richelson and Stan Richelson, read the full article here.

Leave a Comment