Bonds and especially municipal bonds have always been considered the safe haven for investments with stable but small returns. Is it possible for municipal bonds to decline in value?
Here is a real life example, very likely in today’s world. You purchase a $100,000 municipal bond in the City of Rockvillegeneral revenue bonds. A few months later you discover that the city is having difficulty collecting its tax revenues. The city makes its quarterly interest payments on the bonds but makes the payments late because of the slow down in revenue. Now all of a sudden a ratings agency down grades the bonds from AAA to BBB. The bonds immediately begin trading at a 10% discount or $90,000. You have effectively lost $10,000 in current value. At this point, you have a decision to make. Do you hold the bonds and hope that the city recovers and re-establishes its AAA credit rating? The city might recover and be fine. On the other hand it could get into deeper trouble and totally default on the bonds and their value becomes even lower. You can hold the bond until maturity and continue to collect your interest, assuming that the city can make the payments and at maturity you will collect the $100,000.
The above scenario is very real in today’s market. An area that you considered a safe haven, all of a sudden has risks that you thought you were avoiding. An alternative is to buy bond mutual funds or bond exchange traded funds (ETF’s). These funds invest in many different bonds and you invest in the fund. This way you are spreading your risk over a large number of municipalities rather than just one.
The point is very simple; if you are an individual investor, know what you are investing in or have a professional manage your investments for you. It is very important when investing in bonds to do your homework and know the stability of the entity in which you are investing. Otherwise stick with Mutual Funds or ETF’s.