Municipal bonds are a type of debt issued by local governments like states and cities. These bonds are tax deductible and provide a fixed return. Municipal bonds present a higher risk of default than the federal government and so have a higher interest rate. However, states and cities have the power to tax their citizens, making defaults rare. In inflation environments, municipal bonds remain relatively safe investments.
Municipal bonds receive their income to pay bonds through their tax base. Property tax, income tax and sales tax are the main sources. Theoretically, each of these sources of tax does well in an inflation environment as prices and incomes rise. For example, if the average price of consumer goods rises at an 8 percent inflation rate, the sales tax on those goods will rise at the same pace as this rate. However, the fixed bond interest rate remains the same, so it will be easier for the municipality to pay.
As bonds become safer investments in inflation environments, the real returns actually decrease. Real return is calculated as the actual returns minus inflation because that is the added purchasing power from the investment. When you invest in municipal bond at a fixed rate, high inflation eats into real returns and makes your investment riskier. For example, if inflation is 5 percent and your bond interest is 8 percent, your real return is only 3 percent.
Municipal Bond Risks
During times of inflation, secondary effects can put municipal bonds at risk. For example, inflation in the health care industry can put people out of work because the costs to employ them are too high. When fewer people are working, fewer are paying income tax and sales tax, which will directly affect the municipality's tax revenue. As a result, the ability to repay the bond will be diminished.
Municipal bonds are safe investments in times of inflation and deflation. The default rates are extremely low and generally under 1 percent. In 2011, respected analyst Meredith Whitney envisioned hundreds of billions of dollars in defaults of the municipal bond market. Instead, only $6 billion of the $3.5 trillion dollar market went into default. Of that, half was related to a bond that was actually backed by bankrupt American Airlines.
Kathy Zheng is a personal financial planner. She holds a Bachelor of Arts in economics and is certified as a level 1 financial adviser.