SEC Issues Investor Bulletin Regarding Municipal Bonds
The Securities and Exchange Commission’s (“SEC”) Office of Investor Education has issued an Investor Bulletin to help inform investors about municipal bonds (“muni 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. An investor who purchases a muni bond is effectively lending money to the bond issuer in exchange for a promise of regular interest payments and the return of the principal when the bond matures. Short-term bonds mature in one to three years, but a long-term bond will typically not mature for at least ten years.
Generally, muni bond investors tend to be more risk averse and are seeking to generate steady income while preserving their principal. In addition, oftentimes the interest paid on muni bonds is not considered taxable income. The interest rate for tax-free muni bonds is usually lower than on taxable fixed-income securities such as corporate bonds.
The two most common types of municipal bonds are 1) general obligation bonds that are not secured by any asset but are backed by the “full faith and credit” of the issuing municipality and for which the municipality has the authority to tax residents in order to repay the bondholders; and 2) revenue bonds that are not backed by a municipality’s taxing power, but are repaid with revenues from a specific project such as highway tolls.
In addition, municipalities sometimes issue bonds on behalf of private entities such as airports and non-profit hospitals. Typically, these “conduit borrowers” agree to repay the bond issuer, who in turn pays the interest and principal on the bonds to investors. In cases where the conduit borrower fails to make a payment, the municipalities that issued the bonds are not usually required to repay the bondholders.
Investors in muni bonds face a number of risks, including:
• Call risk. The potential that an issuer will repay a bond before its maturity date.
• Credit risk. The risk that the bond issuer or conduit borrower, in the case of bonds issued on behalf of private entities, may experience financial problems that make it difficult or impossible to pay interest and principal in full, such as what happened with the airport bonds linked to American Airlines when its parent company AMR Corporation filed for bankruptcy protection.
• Interest rate risk. A bond’s market price moves up as interest rates decline, conversely, the bond’s market price declines as interest rates rise. If interest rates move higher, investors who hold a low fixed-rate muni bond and try to sell it before it matures could lose money because of the lower market value of the bond.
• Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for bondholders who receive a fixed rate of interest. It may also lead to higher interest rates and, in turn, lower the market value of existing bonds.
• Liquidity risk. The possibility that bondholders won’t find an active market, potentially preventing them from buying or selling their bonds when they want.
As with any investment, investors should consult an investment professional and tax adviser for a full explanation of a municipal bond’s risks, benefits and potential tax consequences before adding it to their portfolio.
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