Although the stock market has been offering high total returns for 2014 — 6.86 percent to be exact — municipal bonds have topped that with an unusually high 8.32 percent return.
A municipal bond is a debt security issued by states, cities and government entities. When states, cities, government entities, etc. need to accumulate money to build anything from sewer systems to highways to hospitals, they issue municipal bonds. Lenders, which can essentially be anyone, will buy the bonds. The money paid in the transaction is used to build these previously mentioned structures. The issuers of the bonds then promise to repay the stated value, called the face value, of the bonds at the end of a certain number of years, typically with interest payments paid twice a year to the lender.
A relationship seen everywhere in newspapers like The Wall Street Journal is that when the price of these bonds go up. The interest rate, known as the yield to maturity on the bond, will go down if more people are buying the bonds, thereby increasing demand, the price of the bond will go up. That being said, since there has recently been a strong demand for these bonds because of their great returns, prices are increasing and more entities can issue municipal bonds because the interest rate is being pushed down. With a lower interest, the cost of borrowing for these entities will decrease so even those states and cities that were worried about borrowing before are now more inclined to issue these bonds.
Many consider municipal bonds as safe as treasury bonds, debt securities issued by the U.S. government, because the repayments to lenders are backed by tax revenues. Tax rates have increased, which only makes the bonds slightly safer and consequently more attractive to investors. And, even though the cost of borrowing has been lowered, not as many cities and states are issuing these bonds. Because of this, there isn’t a flood of supply that would push prices back down and interest rates back up, quite the nice mixture of events for bond-buyers. Actually, the supply of newly issued municipal bonds has fallen by 10.5 percent compared with the same time frame from last year.
Should you really go chasing after investments in these debt securities? One should be cautious because this trend might not continue forever. Buying these bonds now will offer a lower and lower return since interest rates are getting pushed down. Were the interest rates to shoot upward, those already holding municipals wishing to sell them before they mature will find the value of their bonds plummeting; we call this interest rate risk. No one should overpay for these now-expensive bonds if they are going to be taking on more risk. So it is possible that many have already missed the muni bandwagon.
Nov. 6, 2014