Municipal Bond Fraud: When “Safe” Government Investments Aren’t Safe at All

Municipal bonds are supposed to be among the safest investments you can make. After all, they’re backed by government entities with the power to tax. But I’ve seen too many cases where investors lost money on municipal bonds due to fraud, misrepresentation, or unsuitable sales practices.

Let me tell you what can go wrong with “safe” municipal bonds and how to protect yourself.

What Are Municipal Bonds?

Municipal bonds are debt securities issued by state and local governments to fund public projects like schools, roads, and hospitals. They’re popular with investors because:
– Interest is often exempt from federal (and sometimes state) taxes
– They’re generally considered low-risk
– They provide steady income

But “low-risk” doesn’t mean “no-risk.”

Types of Municipal Bond Fraud

Misrepresentation of risks – Brokers downplay or fail to disclose the real risks of certain municipal bonds.

Unsuitable recommendations – Selling municipal bonds to investors who don’t benefit from the tax advantages.

Excessive markups – Charging excessive spreads when buying or selling bonds.

Churning – Excessive trading in municipal bond portfolios to generate commissions.

Fraudulent offerings – Rare but devastating cases where the bonds themselves are fraudulent.

The Tax Trap

Here’s a common problem: brokers sell municipal bonds to investors who don’t benefit from the tax advantages. If you’re in a low tax bracket or holding the bonds in a retirement account, you’re probably better off with taxable bonds that pay higher yields.

I’ve seen retirees with modest incomes sold municipal bonds yielding 3% when they could have earned 5% with corporate bonds and paid little or no tax anyway.

The Markup Problem

Unlike stocks, municipal bonds don’t trade on centralized exchanges. This makes it hard to know what you’re really paying. Some brokers take advantage of this by charging excessive markups.

For example, your broker might buy a bond for $98 and sell it to you for $102, pocketing a 4% markup without clearly disclosing it.

High-Risk Municipal Bonds

Not all municipal bonds are created equal. Some carry significant risks:

Revenue bonds – Backed by specific revenue sources (like toll roads) that might not generate expected income.

Industrial development bonds – Used to finance private projects that might fail.

Tobacco settlement bonds – Backed by payments from tobacco companies that are declining over time.

Pension obligation bonds – Used by governments to fund underfunded pension systems.

These bonds can be appropriate for some investors, but brokers often fail to explain the additional risks.

The Puerto Rico Disaster

One of the biggest municipal bond disasters in recent history involved Puerto Rico bonds. Many investors were told these bonds were “safe” because they were backed by the government and offered attractive tax benefits.

When Puerto Rico’s financial crisis hit, investors lost billions. Many had been sold inappropriate concentrations of Puerto Rico bonds without understanding the risks.

Red Flags to Watch For

Your portfolio is concentrated in one issuer – Even “safe” municipal bonds shouldn’t dominate your portfolio.

You’re in a low tax bracket – Municipal bonds might not make sense if you don’t benefit from tax exemptions.

The yields seem too good to be true – Higher yields usually mean higher risks.

Your broker can’t explain the specific risks – Every bond has unique risks that should be disclosed.

Excessive trading – Municipal bonds are usually buy-and-hold investments.

Due Diligence Questions

Before buying municipal bonds, ask:
– What specific entity is issuing this bond?
– What’s the source of repayment?
– What are the credit ratings?
– What’s the effective yield after taxes?
– How does this fit with my overall portfolio?
– What are the specific risks?

Protecting Yourself

Diversify – Don’t put too much money in bonds from any single issuer.

Understand the tax benefits – Make sure you actually benefit from tax-exempt income.

Check credit ratings – Higher-rated bonds are generally safer.

Compare yields – Make sure you’re getting fair pricing.

Read the offering documents – Understand what you’re buying before you buy it.

What to Do If You’ve Been Harmed

If you’ve lost money due to municipal bond fraud or unsuitable recommendations, you might have legal options:
– FINRA arbitration for broker misconduct
– SEC enforcement actions
– State securities law violations
– Fraud claims

The key is documenting the misrepresentations or unsuitable recommendations and acting quickly.

The Bottom Line

Municipal bonds can be excellent investments for the right investors in the right circumstances. But they’re not automatically “safe” just because they’re issued by governments.

Don’t let the tax benefits or “safe” reputation of municipal bonds prevent you from doing proper due diligence. And don’t let brokers sell you bonds that aren’t appropriate for your situation.

If you’ve been harmed by municipal bond fraud or misconduct, an experienced securities attorney like Robert Wayne Pearce can help you understand your options and potentially recover your losses.

Remember: there’s no such thing as a completely safe investment. Even government bonds carry risks that you need to understand before investing.