If you watch Suze Orman, you know that she LOVES to recommend municipal bonds [1]. Municipal bonds allow you to loan money to a city, county or other local government. They are attractive investments [2] because they are considered nearly risk-free and provide income that is exempt from federal taxes. As the stock market tanked, investors fled to bonds as a way to protect their money. As demand soared, bond prices skyrocketed – even while returns cooled slightly. This combined with the current economic environment has led some experts to ask [3] if municipal bonds (commonly called “Munis†could be the next bubble.
What makes a Bubble
You’ve probably heard the terms “tech bubble†and “housing bubble†tossed about. But do you know what really makes a bubble [4]? Bubbles form when an investment enjoys outsized returns. As a result, investors flock to the investment, driving prices higher. The higher prices attract even more investors, and the price keeps going up. But at some point, the price exceeds a reasonable amount for the return that the investment provides. Investors realize that their investment wasn’t worth it, and start trying to unload the product. As a result, prices fall – often quickly – and the bubble bursts. Those who haven’t managed to unload the investment miss out on the gains they could have had if they had sold sooner. And when bubbles burst quickly, as they often do, investors usually lose some or all of their initial investment as well.
Why Munis could be Next
There are two ways to make money on municipal bonds: by receiving interest payments at regular intervals and then receiving your principal back at maturity, or by selling the bonds for a profit before maturity. With unemployment [5] high and consumer spending still struggling in the wake of the recession, states and municipalities are dealing with lower tax revenue. A few bond issuers have failed to pay bondholders [6] when the bonds mature. Investors who hold munis to maturity lose their initial investment when this happens.
The more common way that munis (or really all bonds) lead to a loss for investors is when interest rates and inflation rise, thus pushing bond prices down. When this happens, it is nearly impossible for investors to sell their bonds at a profit.
Municipal bond demand has remained high, even as returns have begun to stabilize. If the weak economic recovery continues, there might be more defaults [7] on municipal bonds. If the economy stabilizes more rapidly, inflation and interest rates will increase. In either case, municipal bond prices will suffer – and with them, your investment returns could take a tumble.
What you can Do
Just like stocks, go with what you know and diversify. The best way to purchase municipal bonds is through a municipal bond fund. This way you are exposed to bonds from a variety of municipalities, and if one goes sour you won’t lose all your money. You can trust fund managers to get in and out of short and long term bonds as the interest rate and inflation environments change. If you absolutely can’t afford to lose any part of your money or don’t understand how the investment works, keep your money in CDs [8] or Money Market accounts instead.