The investment landscape for municipal bonds has changed in a number of ways. What was true in the past for this asset class may not be anymore, according to Sheila Amoroso and Rafael Costas, co-directors of Franklin Templeton Fixed Income Group’s Municipal Bond Department. They emphasize the importance of exercising discretion when choosing to invest in certain areas of the muni market, but still believe there are good reasons for investors to consider the asset class.

What to Believe and What to Question

We believe it’s time to take a good hard look at the municipal bond market, because what was true 10 years ago, very well may not be true today.

First, here’s what we believe is still true about munis—they are still a great source of tax-free income for a wide variety of investors. Additionally, municipal bonds as an asset class are second only to US government-related issuers in terms of credit quality among US-issued securities. That’s the good news.

So, what may not be true about the market anymore? First and foremost—the treatment of creditor claims by distressed issuers has changed dramatically. Investors may not be able to trust that previously inviolable security pledges like general taxing power and specific tax revenue pledges will still be honored by issuers in times of distress. While we believe that municipal issuers’ ability to pay is generally still second to none, in our opinion, the willingness of distressed issuers to pay has been seriously undermined in the last five years.

The combination of recent municipal bankruptcies, the treatment of creditor claims and the increasing pressure on state and local governments brought on by inexorably increasing public pension and benefit obligations demands a significant shift in how municipal general fund debt must be analyzed. Unfortunately, we think this is now the reality of the municipal-bond landscape, and it may only get worse as more and more cities and states are running out of options to make good on all the promises they have made to their creditors, public employees and taxpayers.

Advisors and investors should be aware of this change in the municipal capital markets and know how their municipal bond management team is approaching investing in munis today. We believe the best way to handle these situations is to avoid them from the beginning, giving wide berth to issuers that appear to have unsustainable budget situations.