Driven by their tax-free interest and current high yields, municipal bonds have continued to be throughout the highlight. More investors have continued in order so as to add the bond variety to their portfolios to profit from these benefits. And, increasingly, they’re choosing so-called general obligation (GO) bonds. Issued by state and native governments, these bonds are backed by the taxing authority of municipalities, giving them an aura of safety.

But just how secure are they compared to other municipal bond varieties?

In response to investment manager Thornburg, perhaps not as secure as investors think. While they feature lower rates of default, the carnage tends to be worse once they do have issues. For investors constructing out their municipal bond portfolios, it pays to be diversified.

The More Popular Municipal Bond Category

Historically, municipal bonds have been a preferred stomping ground for the rich and high-net-worth investors. Issued by local and state governments to help fund public projects or municipal government operations, munis – for probably probably the most part – are free from federal taxes. In some instances, they’re free from state and native taxes as well. This has resulted in an increasing variety of investors of all income bands quickly discovering their benefits.

But, like many corners of the bond sector, not all municipal bonds are the similar. They mainly fall inside two broad categories: revenue-backed bonds and GO bonds.

Despite being just 28% of the $3.8 trillion municipal bonds market, GO bonds are the popular amongst retail investors and are inclined to be what we expect of once we define municipal bonds. GO bonds are issued by state or local governments whose repayment is driven by these entities’ taxing authorities. This differs from revenue bonds whose repayment is driven by the cash flows of a specific project.

As such, GO bonds have long been the best alternative for a whole lot of municipal bond investors. The ability for the State of Texas or the City of Anaheim to lift taxes to cover their bonds adds a level of safety and reduced risk to those bonds.

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Less Secure Than We Think

There could also be data to support the concept that GO bonds are secure for investors – chief of which are their default rates and credit rankings.

Taking a have a look at credit rankings, 62% of all general government bonds, which includes GO bonds, are rated investment grade (Aa3 or higher), while only 41% of revenue bonds have that rating. The flip side is that lower than 6% of GO bonds are throughout the Baa category, which is one notch above junk. That number is over 18% for revenue bonds.

As for defaults, GO bonds rarely go bust. Taking a have a look at all the municipal bond defaults from 1970 to 2020, lower than 1 / 4 of them have been GO bonds. Again, the taxing authority of the state or city has helped keep those defaults low.

But based on Thornburg, this has led investors right right into a false sense of security, because when GO bonds do default, they really go boom. It’s since the dollar amount of the defaults are much greater. Regardless that they comprised lower than 1 / 4 of all defaults, GO bonds were chargeable for over 75% of the dollar volume or value of the defaults. This chart shows the magnitude of the defaults. The group of circles on the left shows the range of defaults throughout the varied muni categories GO bonds (dark gray), utility bonds (green) and competitive enterprises (blue). But you could see by the circles on the most effective that the dollar amount of GO bond defaults has been relatively greater than the alternative 2 categories.

 
Source: Thornburg

Because of this, investors can’t in any respect times assume that GO bonds will keep them secure. Moreover, recent examples have underscored that not all general obligation bonds will keep their guarantees.

Each Detroit’s and Puerto Rico’s recent defaults are examples. During these default periods, each entities stopped paying on their GO bonds but still made 100% payments on their water, sewer, and other essential services bonds. Inside the case of Detroit, town tried to treat its GO bondholders as “unsecured” creditors, and because the bankruptcy was settled out of court, no legal precedent was set determining if GO bondholders is perhaps treated as such. On the similar time, Puerto Rico reneged on the “constitutional priority” of its GO bonds, choosing to safeguard the essential needs of its residents. GO bondholders took significant haircuts in each scenarios.

These two major defaults have thrown quite a whole lot of risk onto the world of GO bonds by the use of future defaults and just how bondholders will likely be treated. While defaults don’t occur as often, once they do, things for bondholders is perhaps very ugly indeed. As such, the market has been repricing risk amid the muni space in recent times. Revenue bonds have historically been higher yielding, and so that they still are. Nevertheless, the spread between GO bonds and revenue bond yields has continued to drop in recent times.

Repricing GO Risk

For investors, Thornburg’s missive on GO bonds and their mispriced risk is definitely food for thought. There are some hidden dangers, and when things do go bust, investors may be with out a life preserver. Overall, GO bonds is not going to be among the finest place for investors to park all their money as regards to allocating to municipal bonds. This idea is just strengthened when you consider that many revenue bonds in recent times have include extra provisions to help support their payments, including the backing of revenue with certain taxes.

Perhaps the one good news is that the vast bulk of investors use ETFs and mutual funds to get their muni exposure. Major muni indices, akin to the ICE AMT-Free US National Municipal Index or Bloomberg Municipal Managed Money 1-25 Years Index, have about 50% to 60% of their holdings in GO bonds. This diversification amongst various muni types should help limit losses even when there’s a major Detroit- or Puerto Rico-styled blowup.

But for investors who do hold individual muni bonds, they’ll probably want to noticeably consider what they hold, and perhaps go broad via an ETF or fund.

Municipal Bond ETFs

These ETFs were chosen based on their exposure to municipal bonds at a low price. They’re sorted by their 1-year total return, which ranges from 0.5% to 2.5%. They’ve expense ratios between 0.05% to 0.65% and assets under management between $930M to $34B. They’re yielding between 1.7% and three.4%.

All in all, GO bonds have long been the “secure alternative” for municipal bond investors. As a consequence of their tax-backed nature, defaults are rare. Nevertheless, Thornburg’s research shows that GO bonds can default – and once they do, it’s an unlimited failure. This is usually a risk that many investors is not going to be considering once they buy these bonds. The reply is to be diversified and perhaps take a have a have a look at revenue-backed bonds for added diversification.

Bottom Line

Municipal bonds have surged in popularity in recent times. Much of that popularity has been squarely focused on GO bonds because of this of their taxing ability. Nevertheless, investors may not want to get too complacent. There are big risks to take into consideration when choosing the GO bond route for municipal bond exposure. Defaults do occur – and once they do, it’s a very big issue for GO bondholders.