So what makes a muni bond safe?
Safety isn’t in the eye of the beholder. It’s an aspect of credit. And credit is simple: either the borrower pays you back or he doesn’t. That’s why I like studying credit: it’s like a pass-fail course where you’re always graded at the end. And if you do your work right, you should pass the course.
Since credit has been around as long as people have been getting loans, what are the characteristics of sound credit? As I’ve studied the bond market I’ve learned that credit comes down to five factors:
First is liquidity—how much cash you have on hand, and how quickly you can raise cash. If you have cash, you’re more likely to pay your debts. Second is solvency—how indebted you are relative to your assets and earning power. For muni bonds, we look at how much debt is outstanding relative to the size of the economy. Third is efficiency. If you do your work with a minimum of expense, you can probably save your way back to solvency. The fourth factor is credibility. If the government is seen as responsible and legitimate, it’s more likely to be able to raise fresh cash when it needs to. The final factor is growth. If an economy is growing well, it can often grow its way out of a fiscal problem.
These five factors all bear on whether a town or a school district or a water system will be able to pay its debts. As we know, not all of them do. But most of them do. In the past 40 years bonds have been issued by almost 100 thousand different creditors. Only 54 of them have defaulted.
The vast majority of muni bonds are safe. By examining their liquidity, solvency, efficiency, credibility and growth we make them even safer.
Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!
Follow me on Twitter @GlobalMarketUpd