Municipal Investments: Analysis & Diversification

Instructor: Yusuf Abdullah

Yusuf has taught Science and Mathematics at school level and Finance and Economics at University level. He has recently earned his Ph.D in Financial Econometrics.

In this lesson, you'll learn about the diversification of municipal investments using different municipal securities. We'll explain how to diversify the municipal investments on the basis of geographical location, type, and ratings.

Municipal Investments

Municipal investments are municipal securities issued by local and state governments. These securities can be tax-exempt on the federal level and are hence a good source of income. The municipal securities are a good diversification tool when used in conjunction with other asset classes such as other debt, equity, real estate, commodities, etc. The municipal fund market offers a large variety of municipal bonds with different risk and return characteristics. This leads to considerable diversification options within the municipal asset classes.

Since municipal bonds offer large diversification benefits, Rachel, a barista at Central Perk, has decided to invest in them. However, she wonders if there are options of diversification within the municipal bonds themselves to further reduce risk. Therefore, she approaches Monica, a financial advisor to get proper advice. The first question that she has for Monica is whether she would be taxed on municipal securities issued outside her home state of New York?

Geographical Diversification

While municipal bonds offer diversification, they lose out on the tax-exemption if the buyer is not from the same state as the issuer. Therefore, Monica informs Rachel that if she buys municipal bonds issued outside New York, she will have to pay taxes on the interest income. This might affect the total return from these investments. However, bonds from different geographical areas reduce the risk considerably. For example, consider a municipal bond that draws its income from the toll collected on a bridge in New York. If there is a hurricane and the bridge is destroyed, then the risk would be very high. Diversifying would be a good option to reduce risk even if it means foregoing a part of the tax-exemption. Therefore, geographical diversification in the case of municipal bonds refers to buying bonds from different states and projects in different geographical areas within the states or outside it.

Rachel is not happy but decides to heed Monica's advice to diversify into municipal bonds of other states for lesser risk. With different states and different projects funded by the municipal bonds, a considerable amount of diversification is possible. However, there is a drawback to the municipal bond investments. Since there are so many types and some issues are smaller, a majority of the bonds do not trade daily and are hence comparatively illiquid. This also makes sense to diversify into different bond issues across the US.

Type Based Diversification

Rachel properly understands the need for diversification. She wants to know if there is another way to diversify so that she can keep a majority of her municipal bond portfolio issued by the issuers in New York and get tax-exemption. Monica advises her that it can be done by diversifying into the types of municipal bonds based on cash flow sources. They are of two types:

  • General obligation bonds are backed by the taxation power of the issuing entities ,which are governmental in nature. For example, the bonds issued by New York City would pay interest from the taxes levied by the city.
  • Revenue bonds are backed by the revenue generated from the projects for which the bonds have been issued. A New York bond issued to construct a bridge would pay back the investors from the tolls generated by the bridge. These bonds cannot be paid from the taxes levied on New York citizens.

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