These days, with Treasury bond yields down, tax-exempt municipal bonds (munis) look like attractive investments. However, investors need to be careful before investing because some munis are tied to dicey revenue streams – instead of being guaranteed by the city or state’s general fund.
These risky municipal bonds tend to fall into four categories:
1. “Dirt” bonds – These were issued during the Housing Boom by cities partnering with home builders. The home builders would build new subdivisions and the city would raise money for services by designating the subdivision as a bond-issuing district. These bonds would not be backed by the city’s full taxing authority. Instead, they would be repaid by an assessment on the new home-owners.
The problem is that many builders are now in financial trouble, and many of these subdivisions are only partially occupied. Spreading the costs among fewer houses are resulting in high assessment fees that the homeowners do not want to pay.
2. Tobacco bonds – These are bonds issued by states that are repaid by the proceeds from the 1998 settlement between cigarette makers and the states. The concern is that the states, which are now experiencing financial difficulties, keep raising cigarette taxes. These reduce the amount of tobacco use and the revenue of the tobacco companies. Many states, such as Ohio, do not guarantee the bonds. Thus, buying a tobacco bond is like a 20 year bet that cigarette makers will stay healthy and the settlement will stay legally viable.
3. Redevelopment agency bonds – These bonds raise money to fix run-down neighborhoods and are repaid by property taxes on the improvements. With the real-estate crisis, a lot of these neighborhoods have high foreclosure rates.
4. Lease bonds – Here, a city issues these bonds for a real-estate project, such as a new fire station, and the bonds are paid by a “rent”. These bonds allowed cities to avoid the need for voter approval – which is required for bonds backed by general revenue. This makes them risky because, for example, if the fire department is too cash strapped to pay the “lease” on the new station, the city may not be able to legally pay it.
Praveen Puri has 20 years of trading and investment experience – including serving as a consultant to major insurance companies, banks, and the Chicago Board of Trade. He is the author of Stock Trading Riches, which details a mathematical stock trading method that isn’t exciting or “sexy”, but is extremely lucrative.