MONEY OBEDIENCE

Municipal Bonds vs Stocks

A few days ago I attended a seminar about municipal bonds. What are municipal bonds?

In short, municipal bonds are certificates issued by a municipality like a city or another local government and their agencies – you buy the certificate, and your payment is considered a loan that will be paid back, with interest, according to set terms.

The basic idea of the seminar was that municipal bonds are the best investment in the long run for an investor with high income. In the US the interest income you get from municipal bonds are often exempt from federal taxes and from state income taxes in the states where they were issued. This feature makes bonds very attractive to investors whose incomes are taxed at high rates – they potentially get the most out of the tax benefit that comes with investments in bonds because these municipal bonds earn tax-free interest.

Municipal bonds have historically given investors solid returns after inflation and taxes were taking into account, especially compared to other investment options. To make this point, the seminar speaker presented a chart showing the Dow Jones Index over the last 10 years returning nothing to investors, all along bouncing up and down. He said that he could have used any 10-year period to make his point. He probably meant to make the point about the bouncing rather than about the returns, although it was implied that he could make the point about either one with any 10-year chart of this index.

Truth is, though, he cannot make both points with any 10-year chart. It is only true that you can take any 10-year period to show that stocks move erratically. But you need to show the last 10 years to make the point that stocks don’t return much to investors. In most other 10-year periods equities have performed much better, especially when you look at returns after you account for inflation. (See “S&P 500: Total and Inflation-Adjusted Historical Returns.”) Inflation tends to hurt (municipal) bond investors more than it hurts equity investors. Fortunately for municipal bond investors, inflation has not been a problem since the 1970s. But that is not to say that inflation could not be a problem in the years to come. So, it’s not always the case that (municipal) bond investments are the better way to go.

Besides inflation, there is another potential problem with municipal bonds: the current state of public finances. The worse a municipality’s finances get, they more likely it is that a municipality will default on its bonds and not pay the interest or even the principal to investors. This has not been a problem for a long time, bar a few exceptions like New York City in the 1970s and Orange County in 1994. But recent news indicates that the finances of local governments are getting pretty tight. (For news articles on this, please click on the links below!) Tight municipal finances make a default on municipal bonds more likely and ultimately costly for investors. So, caution is in order.

Bottom line: municipal bonds are one of many investment vehicles that an investor should look at. But no investment has guaranteed returns. Municipal bonds are no exception.

Please keep in mind that we are only relaying our opinion about municipal bonds. Do not use our opinion as a basis for your investment decisions. Please also keep in mind that by reading this blog you agree to the site’s User Agreement.

News articles:

Despite Wealth, Nassau County Is in Fiscal Crisis

Mounting Debts by States Stoke Fears of Crisis

U.S. state and local finances in big double-dip risk

Excessive Debt Weighs Many U.S. States, Local Governments

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Posted in Investing