Would you lend money to the city of Chicago, given its troubled school financing and its underfunded pension systems that will require huge tax increases to remain solvent? Sounds pretty risky, and yet the city was recently able to sell $500 million of its bond IOUs a few months ago, despite their "junk" ratings. The attraction: a 4.9 percent tax-free yield.
In a world of almost zero yield, some investors are willing to take high risks, betting that cities like Chicago and Atlantic City, as well as the state of Illinois and the commonwealth of Puerto Rico, will find a way to pull out of their financial crises instead of defaulting on their debt.
Obviously, not all states and cities carry such high risk. But how much is too much risk to take when it comes to your own savings? Here are five things to know about municipal bonds before you jump for those high yields.
-- They have considerable tax benefits. Muni bonds are IOUs issued by cities, states and other local taxing bodies to finance public-purpose investments, ranging from roads to hospitals and airports. The interest on their bonds is free from federal income taxes and state income taxes for residents. Some are even be free of city income taxes where applicable. That tax-free provision makes the yields significantly higher than taxable equivalents.
-- The type of municipal bond matters. Some bonds pay interest out of the general funds raised by the taxing authority. They are known as general obligation bonds, or GOs. Others pay their interest based on revenues from a specific project or purpose -- such as a toll road or airport landing fees. Traditionally, GO bonds have been considered more secure, but as state and city budgets have suffered, many sophisticated investors have begun to prefer a revenue stream they can count on from a specific project.
-- Buying municipal bonds can be expensive. You can buy individual municipal bonds through a broker, but you'll likely pay too much! Small lots of bonds trade infrequently -- and prices on purchase are typically marked too high for the uninformed small investor. They also typically get a price that is too low when it comes time to sell.
The only time bonds are priced fairly for small investors is when they participate in an original sale of bonds from a municipality -- not when bonds are purchased in the trading aftermarket. But there is a website, EMMA.msrb.org, that can give you current price information on almost every muni bond.
-- Small investors are better off buying municipal bonds using bond funds. Some funds are set up as a trust, with a fixed investment in bonds that are held to maturity. Other funds have a manager who buys and sells bonds based on research and changes in market conditions. There are also municipal bond exchange traded funds (ETFs). Recently, Vanguard created the market's first tax-exempt muni index open-end mutual fund, along with an ETF based on the index.
To research municipal bond funds, go to Morningstar.com and search the category, comparing the riskiness and maturities of each fund, as well as the yield.
-- Bonds carry risks you must understand. Like all bonds, municipal bonds carry a market price risk as well as a credit risk. The market risks occur regardless of credit quality. When interest rates rise, bond prices fall. And that could cost you money if you sell your bonds or bond fund.
While the lure of high-yielding, tax-free investments is especially enticing in these days of low interest rates, don't be blinded by those numbers. Risk and return are the opposite sides of the coin. And that's The Savage Truth.