Risks

While most municipal securities have low default risk, it isn’t zero. It’s very rare for general obligation (G.O.) bonds to default, but revenue bonds carry more default risk. In fact, revenue bonds default at 13 times the rate of G.O. bonds. Even so, revenue bond defaults are still relatively uncommon overall.

Liquidity risk is much more common than default risk in the municipal market. Many municipal bonds trade infrequently - often fewer than 50 times per year. For comparison, the average daily trading volume for Treasury securities in 2018 was $547 billion!

Liquidity risk is driven by who is likely to trade the bond. If you try to sell a municipal bond issued by your city, who are you most likely selling it to? In many cases, it’s other investors who focus on that same municipality or region. Municipal bonds often don’t have the same broad national or global trading audience that corporate bonds and U.S. government securities do.

Notice that the overall size of the municipal market isn’t the main issue. The municipal market is large - it was estimated at a size of $3.9 trillion in 2019. The challenge is that many individual issues still trade in a relatively small, localized market.

Liquidity risk is especially noticeable for smaller municipalities. For example, Wyoming had a population of 578,759 in 2019. Even if that sounds like a lot of people, only a small fraction are municipal bond investors. And among those investors, only some will be ready to buy at the moment another investor needs to sell. As a result, bonds from Wyoming - and especially from smaller cities or localities within Wyoming - can face significant liquidity risk. In general, the smaller the municipality, the higher the liquidity risk.

The last risk relates to yield. We discussed the benefit of tax-free income from municipal bonds in the previous section, but that benefit comes with a tradeoff: lower yields. Issuers know they can offer lower yields because investors don’t pay taxes on the interest.

This isn’t always a deal-breaker, but it matters most for investors in low tax brackets. If your tax rate is low, a municipal bond’s tax advantage may not be enough to make up for its lower yield. In that case, choosing municipals can create opportunity cost - you may earn a lower after-tax return than you could with a taxable investment.