There aren’t many people that are opposed to municipal bonds. My high net worth clients like them for their tax-free income, and most of my Socially Conscious clients like them as they inherently support the enhancement and betterment of our communities.
Many money managers are hot on municipal bonds (also referred to as munis) right now, as many are paying attractive yields with even higher tax-equivalent yields, all at a tax-free rate.1 When you can get a tax-free 4%+ dividend, that’s hard to ignore! Though many money managers are looking to high-yield (or, junk bond status) options for the higher dividend, it’s not necessarily as risky as it sounds, at the moment, anyway. In most other years, yes, this might be an issue, but this year, due to the coronavirus, many municipalities have been given large stimulus packages to hold them over. But we won’t live in a COVID-stimulus economy forever, so we need to start acknowledging the other risks involved with munis and be willing to look behind the curtain a little when we consider this asset class.
Most investors look to bonds to add stability and predictability to their portfolio. What happens if their bonds are rated well but have deep imbedded risks? The average bond maturity in the municipal bond market is 13.02 years.2 What climate changes could and will occur in the next 13.02 years that will influence the municipality’s ability to pay their investors?
Currently there are a few threats looming over munis. Not only are they expensive (selling at a premium price), but eventually COVID-related uncertainties such as costs and tax revenue, will likely come in to play. What may surprise many is an additional threat- the threat of Climate Change on a municipality’s balance sheet.
Some experts have claimed climate change is a “threat multiplier” for municipal bond owners in that climate events such as floods, fires, extreme heat or cold, etc. will magnify existing credit weaknesses of the bond issuers.3 Not only do these events cause pressure on municipalities’ ability to make payments on their bonds, but we should expect these events will continue to occur more frequently and more severely. Many effects of climate change are already being felt. For example, if a bond was issued for maintenance of a 30-year road project, both temperature changes and extreme wear and tear from snow plows and salt damage could result in even larger than expected costs. What happens then? Do they issue another bond to help pay for the additional costs?
One of three big U.S. credit-ratings companies, S&P, researched public water utilities. They were specifically looking at whether or not the location of a public water utility had any correlation to their financial strength. It turns out that utilities located in ecosystems that foster better water quality, such as evergreen forests, were associated with better debt metrics.4 They chose to research water utilities and their geographic location because of the potential for droughts or scarce supply in high-growth areas, making it especially susceptible to climate change.
So what is the solution to this? First, not all muni bonds are the same. Some are general obligation bonds and some are revenue bonds. A general obligation bond is backed by the general revenue of a municipality whereas a revenue bond is supported by the specific revenue source (think: toll road, paid parking structures, stadium, or convention centers, or sewage bonds). From the perspective of safety, a revenue bond is less risky than a general obligation bond. So make sure you understand the type of bond you’re considering. Secondly, look at the geographical location of the municipality and determine which environmental threats it is most susceptible to. Third, consider diversification. Rather than investing in an individual muni consider investing in a mutual fund where there are many different munis wrapped into one investment. This spreads out the risk a little. Lastly, have an SRI knowledgeable advisor review your portfolio to make sure the muni risk is appropriate for you and your portfolio. You might find that another type of bond would be more appropriate in terms of risk, taxation and/or expected performance. There are many different types of bonds in the marketplace, so don’t feel cornered and buy something you might not feel good about.
1 Not all munis are tax-free. Many are only state tax-free, some are both state and federal tax-free.
2 Q2 JPMorgan Asset Management. Guide to the Markets. 31 July 2020. Fixed Income Market Dynamics page 35.
3 DeMasters, Karen. Financial Advisor Magazine. Munis Threatened by Climate Risks. 8 September 2020.
4 Albright, Amanda and Mallika Mitra. Satellites Are Helping Municipal-Bond Market Asses Climate Risk. Financial Advisor Magazine. 8 February 2020.
Bonds have fixed principal value and yield if held to maturity. Prices of fixed-income securities may fluctuate due to inflation, credit and interest rate changes. Investors may lose money if bonds are sold before maturity.
Diversification may help reduce, but cannot eliminate, risk of investment losses. Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal.
Carrie Waters Schmidt is a registered representative of Lincoln Financial Advisors Corp. Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Equanimity Wealth Planning and Investing is not an affiliate of Lincoln Financial Advisors. CRN-3268179-100220