Understanding the Risk of Municipal Bonds
When investors consider purchasing municipal bonds, there are many areas to understand. The SEC has provided a checklist of areas to pay special attention to when making this type of investment decision.
What Are Municipal Bonds?
- Municipal bonds are debt securities issued by states, cities, counties, or other government entities.
- They are used to finance and fund government obligations and projects.
- Essentially, the investor is lending money to the government and the investor will be paid back regular interest payments and the original investment amount (principal).
- There are different types of municipal bonds.
General Obligation Bonds
- This type of bond is issued by the governmental entity and backed by dedicated taxes, not by revenue from a specific project or source.
- They are payable from general funds; this is known as being backed by the “full faith and credit of the governmental entity.”
- In some instances the entity responsible for repaying the bond has unlimited authority to tax residents to repay bondholders.
- These are bonds backed by revenue from a specific project or source.
- Municipal entities usually issue these bonds on behalf of other borrowers.
- The issuer pays the interest and principal on the securities from the revenue provide by the conduit borrower. Then the underlying/conduit borrowers will likely agree to repay the issuer.
- Ex. A non-profit college (the conduit/underlying borrower) wants to start a project. A governmental entity (the issuer) will issue bonds on the college’s behalf. The college will repay the government entity; while the government entity repays the investor from the “revenue” provided by the college.
Benefits of Municipal Bonds
- The issuer/obligor will repay you, the investor, your principal along with additional interest payments.
- The interest paid on municipal bonds are exempt from the federal income tax, and occasionally state and local taxes.
Risks of Municipal Bonds
Credit Risk (Also Known as Default Risk)
- This is the risk that the bond issuer fails to pay the interest and/or principal on time and in full.
- This risk is affected by many different factors.
- Credit ratings are simply a view of the bond’s credit risk at a specific point in time.
- This is something that cannot solely be relied upon because it is an assessment of only one aspect of the bond.
- Additionally, credit rating agencies are paid by the issuer and each agency has their own methodology in rating bonds.
Financial Condition of the Issuer/Obligor
- An issuer/obligor needs to be financially sound to have the feasibility to re-pay the investor.
- Some areas to consider regarding repayment feasibility are;
- Debt and long-term liabilities of the issuer/obligor,
- The local economy, and • The audited financial statements of the issuer/obligor
Source of the Repayment Funds
- Some bonds are repaid from a specific payment stream (i.e. Revenue Bonds); the investor must evaluate the viability of the source of the payments.
- Two areas to view are:
- Economic or social trends, and • Statutory limits on raising revenues.