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.

Revenue Bonds

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

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.