Investor Education: Muni Bond Credit Risk
The Securities and Exchange Commission (“SEC”) recently issued an Investor Bulletin urging investors to independently assess a municipal bond’s credit risk, rather than relying solely on a particular bond’s credit rating, before making the investment. Credit risk, also known as default risk, is the likelihood that a bond issuer will not pay the interest and/or principal on the bond in full, when due.
Municipal bonds (“Muni bonds”) are debt securities issued by states, cities, counties and other governmental entities to provide financing for capital projects such as building roads and schools. Effectively, a muni bond purchaser is lending money to the bond issuer in exchange for a promise of regular interest payments and the return of the principal when the bond becomes due.
Prior to investing in a particular muni bond, investors should consider the following factors:
• type of muni bond (general obligation or revenue);
• non-recourse financing (meaning, if the payments on the bonds are not paid, the bondholders do not have a claim against the borrower or on the underlying revenue source);
• purpose of the financing;
• financial condition of the issuer or borrower; and
• other sources of funds to pay the principal and interest (i.e. highway tolls to repay a bond used to build the highway).
Muni bond credit ratings are an assessment by credit rating agencies of a particular muni bond at a particular moment in time. Credit ratings may change over time. The credit rating reflected on a bond’s offering materials may not be the credit rating at the time of purchase, if the bond is bought at a later date. It is also notable that credit rating agencies are generally paid by the issuer whose bonds it is rating. In addition, each agency has its own criteria and methodology when creating the ratings.
For more information, see Investor Bulletin: Municipal Bonds – Understanding Credit Risk; and FINRA Investor Alert: Municipal Bonds.