Puerto Rico’s debt crisis has caused a lot of uncertainty in parts of the municipal bond market. Once considered a safe-haven investment class, bondholders are questioning how much capital they’ll be able to recover from their troubled muni bond holdings.
The debt crisis demonstrates the importance of paying attention to details. While most people group muni bonds into revenue and general obligation (GO) bonds, the reality is that there are many different subclasses of bonds within each of these categories. Bondholders should understand these differences in order to avoid taking on excessive risk.
In this article, we’ll take a look at various types of general obligation muni bonds and the details that bondholders should carefully consider prior to investing.
Differences in Taxation
The largest differentiator between general obligation municipal bonds is the taxation base that ultimately funds repayment of the bonds.
The safest type of GO bond is backed by a dedicated tax pledge and unlimited taxing authority. Often times, these bonds are secured with property taxes that a municipality dedicates to repayment rather than general funds. Property taxes are widely considered to be the safest source of funds — they tend to be more consistent than income tax and people have a strong interest in paying property taxes to avoid losing their homes.
The second safest type of GO bond is backed by unlimited taxing authority alone. In this case, there’s no dedicated tax set aside to cover repayment of the bonds, but a municipality can raise taxes in order to make payments if needed. These taxes can be increased in unlimited amounts – at least in theory – which makes the bonds a relatively safe bet, as long as the municipality isn’t already facing severe troubles with its economy.
The least safe type of GO bond is backed by limited taxation. While these bonds are repaid using general taxation, the government may not have the ability to raise taxes by an unlimited amount. This introduces the risk that the government may be unable to meet its own internal obligations and then be unable to raise taxes to fund repayment. The risk of default is still relatively low – only eight GO bonds have defaulted since the 1970s – but it does exist.
Building a Portfolio
Investors should keep these risks in mind when building a well-rounded portfolio of equities and bonds.
Those looking to build a safe municipal bond portfolio should start with a core of general obligation bonds that are backed by unlimited taxation, and ideally, a dedicated tax pledge. In these cases, there is a very low probability of default. The downside is that yields may be lower given the reduced risk and investors may require additional higher yielding securities in order to bring after-tax yields up to an acceptable level in their portfolios.
Bondholders looking to take on a bit more risk, may want to consider lease revenue bonds that are backed by lease revenues paid by a government for use of a property or enterprise revenue bonds that are backed by utilities (usually private). These bonds are significantly riskier than GO bonds, but they may offer higher yields that are appropriate for a smaller slice of a larger portfolio in order to bolster after-tax returns while remaining diversified.
The Bottom Line
Puerto Rico’s debt crisis highlighted the importance of analyzing municipal bond holdings to ensure that they’re safe and secure. While most investors are familiar with revenue and general obligation bonds, few know the specifics of the bonds that they’re purchasing with regards to the source of tax revenue for repayment. Investors should carefully consider these factors when purchasing bonds, particularly in high-risk municipalities.