First, sovereign entities can go effectively bankrupt. Credit analysis (that is, can they pay?) is as essential in municipal bond investing as it is in corporate bonds.
Second, unlike with corporate bonds, investors aren’t necessarily first in line. Pensioners, for example, have historically had their benefits preserved even as investors got hit. In San Bernardino’s bankruptcy, investors lost 60 percent of their money while retirement benefits remained intact, and that looks likely to be the case in Puerto Rico as well.
Third, despite both of these factors, municipal bonds continue to attract investors with very strong pricing right now. The market is not broken and doesn’t look likely to break.
It boils down to this: Municipal bonds carry risk, just like any other investment, so be careful what you buy. That said, the asset class is solid enough that even a major default, like Puerto Rico’s, won’t take it down any more than, say, Enron took down the stock market.
In the end, the situation in Puerto Rico should turn out to be no more important than any other municipal and nonmunicipal restructurings. We can learn from this, but it’s not the end of the world.
Municipal bonds are federally tax-free but may be subject to state and local taxes, and interest income may be subject to federal alternative minimum tax (AMT). The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by McMillan.