[Updated by Joshua Hudson on July 20, 2017]
The recent downgrade of Illinois to one notch above junk status is a troubling development for the muni market.
Fortunately, there are still many high-quality municipal bonds from which to choose. Let’s take a look at the top 10 safest municipal bonds in terms of credit risk.
A Brief Primer on Muni Bonds
Municipal bonds or muni bonds are issued by municipalities such as states, counties and local governments to finance projects for public services. The municipal market totals $3.8 trillion in debt outstanding according to this report from SIFMA.
Individuals are the largest holder of municipal bonds, accounting for 43% of the market due to the preferential tax treatment of tax-exempt muni bonds. In addition, munis are a high-quality alternative to U.S. Treasuries since many munis receive high credit ratings and have low default rates. A handful of municipalities are even rated AAA by all three rating agencies.
Finding Safety in Muni Bonds
The Electronic Municipal Market Access (EMMA) website provides a breadth of tools to help track muni bonds. Simply enter a CUSIP or complete an advanced search to find a specific muni bond. From there, you can view the basic information related to the bond including coupon rate, maturity day, recent financial statements, recent trade prices and current credit ratings.
Here are a few important notes to keep in mind when researching:
- Size Sometimes Matters. Muni bonds issued by larger municipalities aren’t necessarily more financially sound, but they are likely to be easier to sell with more liquidity. In general, investors should pursue municipalities with a population of over 10,000.
- Choosing the Right Type. There are many different types of muni bonds, including revenue bonds or general obligation bonds. Most of the time, general obligation bonds are considered the safer investment, although they often pay a lower yield.
- Watch Credit Ratings. Muni bond credit ratings are extremely important to the lay investor as these ratings reflect the credit risk of the bond. Investors should choose bonds with credit ratings that meet their risk tolerance.
- Looking for Insurance. As of September 2016, approximately 6% of new muni bonds issued were covered by bond insurance that guarantees payments of interest and principal in the event of a default. Bonds with insurance trade at lower yields than similarly rated uninsured bonds due to the extra protection.
- Common Sense. Municipalities with thriving downtowns, growing populations and improving economics represent the safest investments, while investors should avoid those moving in the opposite direction.
- Be Wary of Certain Bonds. Bonds with special labels such as “Green Bonds,” MUDs (Municipal Utility Districts), AMT (Alternative Minimum Tax) and bonds backed by appropriations can be riskier. These bonds require additional analysis to consider the risks unique to the type of bond.
Keeping Track of Muni Bonds
Municipal bond holders should be concerned with two things: changing technical aspects of the bonds and the underlying health of the municipality. The first of these elements can be tracked using the EMMA platform’s “continuing disclosures,” which supports automatic email alerts designed to keep investors up to date. However, the second item requires a bit more legwork on the part of the investor to ensure the safety of their investment over time.
Continuing disclosures contain information about the financial or operating condition of the issuer as it changes over time and specific events that could impact the bond’s valuation or its ability to make payments. Mandatory disclosures are made under contractual agreements entered into under Rule 15c2-12 of the Securities and Exchange Act of 1934, while voluntary disclosures are made without any contractual obligations to do so. In addition, the SEC has created the Municipalities Continuing Disclosure Cooperation Initiative to address violations of continuing disclosures laws.
Ratings agencies like Standard & Poor’s, Moody’s and Fitch provide the most accessible information about the underlying health of municipalities via their bond ratings. Investors can find these ratings on any number of websites or online brokers. Additional information about the health of a municipality can be found in that municipality’s public records, which are often available online or at the relevant clerk’s office.
Top 10 Safest Municipal Bonds
The bonds included here are all AAA rated, thereby minimizing the credit risk. In order to keep interest rate risk low, only bonds have been considered that would mature or be called (in the case of pre-refunded bonds) within the next 5 years have been considered. As a result of the lower risk, these bonds will yield less than more risky bonds.
- Frisco TX ISD (35880CBJ2): Guaranteed by the Texas Permanent School Fund and one of the fastest-growing school districts in the country.
- Missouri St Highways & Transit Commission (60636WJH9): 2016 debt service coverage exceeded 8x on senior lien bonds.
- Texas State Water Development Board (882854VX7): Debt service coverage projected at 3.72x in 2017 and rising each year thereafter.
- Virginia State GO (928109P35): Backed by full faith and credit of the state. Virginia has reported a lower unemployment rate than the U.S. national rate for the past few years indicating the labor market is stronger in the state. The state also has very low levels of debt at just $787 per capita.
- North Carolina State GO (658256L59): Backed by full faith and credit of the state. North Carolina has the second-highest state pension funding level in the country at 95.5%. The state also reported positive operating performance in 2015 and 2016, with total revenues exceeding expenses in both years.
- Maryland State GO (574193BL1): Backed by full faith and credit of the state. Despite the small land area, Maryland is growing its population and personal income levels. The state relies primarily on revenue from income and sales taxes.
- Utah State GO (917542TW2): Backed by full faith and credit of the state. The U.S. Census Bureau reported in December that Utah is the fastest-growing state in the nation with a 2% increase in population in a year. A higher population leads to increased tax collections to support bond payments.
- Georgia St Road & TollWay (37358MCY5): Backed by proceeds from state motor fuel tax and state’s full faith and credit.
- Georgia St GO (373384LP9): This bond has been pre-refunded to the call date on 1/1/19 and is, therefore, backed by U.S. Treasuries as collateral. Pre-refunded munis backed by U.S. Treasuries are the safest munis available.
- Tennessee St GO (880541ML8): Another state GO that has been pre-refunded to the 5/1/18 call date.
The Bottom Line
There are still safe options for muni investors. By choosing AAA state GOs and keeping duration exposure low, credit and interest rate risk can be minimized while still gaining the benefits of municipal investing.