Risks

While most municipal securities are safe from default risk, this isn’t always the case. While it’s very rare for general obligation (G.O.) bonds to default, revenue bonds face higher levels of default risk. In fact, revenue bonds default at 13 times the rate of G.O. bonds. However, revenue bond defaults are still fairly rare in the grand scheme of finance.

Liquidity risk is much more common than default risk. Most municipal bonds are subject to a considerable amount of liquidity risk. In fact, many municipal bonds trade less than 50 times a year. To put this in comparison, the average daily trading volume for Treasury securities in 2018 was $547 billion!

The trading audience is what drives liquidity risk. If you try to sell a municipal bond from your city, who do you think you’re attempting to sell the bond to? Other residents of your municipality in most cases. Municipal investors don’t trade securities with a national or global audience like corporate and US Government security investors do. The overall size of the market is not what drives the liquidity risk of municipal bonds. The municipal market is huge - it was estimated at a size of $3.9 trillion in 2019.

Liquidity risk is especially apparent for smaller municipalities. For example, Wyoming had a population of 578,759 in 2019. While this sounds like a decent amount of people, how many of them trade municipal bonds? And for those that do, how many would be willing to trade when an investor needs to liquidate? Bonds from Wyoming, or especially cities or localities in Wyoming are subject to significant levels of liquidity risk. The smaller the municipality, the higher the liquidity risk.

The last risk to discuss relates to yield. We discussed the benefit of tax-free income from municipal bonds in the previous section, but this benefit doesn’t exist for free. The drawback of tax-free income is low yields. Issuers know they can offer their bonds at low yields because of the lack of taxes investors pay on the interest. While it’s not the most devastating risk, an investor at a low tax bracket should avoid municipal investments. Otherwise, they’re experiencing opportunity cost when other investments could pay them a higher after-tax return.