Fort Bend Business Journal Articles

2010-09-01 Tax-Free Doesn't Mean Risk Free

Municipal bonds are fixed-income securities issued by local governments to raise money for specific projects or a general fund. To facilitate the purchase of these bonds, the federal tax code exempts the interest paid to the bond buyer. At top marginal tax rates, this equals a savings of 35 percent when compared to taxable bonds.

Examples of municipal bonds in Texas include bonds issued by MUDs (Municipal Utility Districts). MUD bonds are issued to build the infrastructure of an existing community or new development. In order to prevent excessive speculative lending, for every $1 issued in bonds there must be $10 in asset value. Because the bonds are backed by the tax base of the community, they are generally considered safe investments. But safe doesn’t equal risk-free in today’s environment.

There are two primary risks to consider when purchasing municipal bonds. First, what is the creditworthiness of the issuer (i.e. community)? Several municipalities overextended themselves during the real estate bubble, and not surprisingly, they’re having a difficult time servicing their debt now that real estate prices have declined and foreclosures have removed taxpaying residents. While defaults from municipalities are relatively rare (only 54 since 1970), there also is the risk that instead of defaulting, the issuer will extend the repayment schedule, which will lower the return. Considering the magnitude of credit problems during the past three years, it is important to know who the issuers are and in particular, their credit ratings.

Also be aware of changes in interest rates. A bond yielding 4 percent in today’s environment is quite attractive. That same bond would definitely not be attractive if rates were to rise 3 percent from current levels. The bond would have to fall in value to make it comparable to higher-yielding bonds.