Question

“Municipal bonds are risk-free securities”. Discuss.

Answer 1

"Municipal bonds (or “munis” for short) are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways or sewer systems. By purchasing municipal bonds, you are in effect lending money to the bond issuer in exchange for a promise of regular interest payments" - As defined by US securities and exchange commission

Municipal Bonds are not entirely risk free bonds, but they have low risk.

They do carry following risks -

1. Credit risk or Default Risk - The issuer (municipalities) may not be able to pay interest and principal in full because of poor financial health or cash flow related issues.

2. Call risk. Many municipal bonds are “callable,” so investors who want to hold a municipal bond to maturity should research the bond’s call provisions before making a purchase. If the interest rates decline, Callable Munis can be called upon and the issuer has to repay a bond before its maturity date. Bond calls are less likely when interest rates are stable or moving higher.

3. Inflation risk. Munis carry inflation risk as well. A higher Inflation in overall economy can lead to higher interest rates and, in turn, lower market value for existing bonds. Inflation also reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.

4. Interest rate risk. If interest rates move higher, investors who hold a low fixed-rate municipal bond and try to sell it before it matures could lose money because of the lower market value of the bond.

If bonds are held to maturity, the investor will receive the face value amount back, plus interest that may be set at a fixed or floating rate. The bond’s market price will move down as interest rates move up.

5. Liquidity risk. Liquidity risk is the risk that investors won’t find an active market for the municipal bond, potentially preventing them from buying or selling when they want and obtaining a certain price for the bond.

The investors who buy municipal bonds to hold them rather than to trade them outnumber the ones who buy it to trade. Market may not be very liquid.