Assessing Municipal Bond Credit Risk Key to Investor Protection, Says SEC
Municipal bonds are debt securities issued by government entities. Investors lend the
issuer money in exchange for a promise of regular interest payments and
– once the security’s maturity date is reached – a return
of principal. While investors typically believe the issuer is the one
ultimately responsible for repaying the principal and the interest on
the bonds, this is not always the case. In some instances, the obligor
or “obligated person” is a third-party borrower – another
governmental entity, a non-profit entity, or even a for-profit firm. reccomendation
These third-party borrowers can greatly impact the bond’s overall
credit risk. While investors generally view bond securities as safe, this
can only be true if the issuer or other obligor will be able to repay
the principal in full upon the security’s maturation date, which
is often many years in the future. The financial condition of the issuer
or underlying borrower, therefore, should be a key concern of investors
purchasing a bond. Unfortunately, credit ratings – which many investors
rely upon to provide an accurate assessment of the bond’s current
credit risk – do not tell the entire story.
"You should be aware that because [municipal bond] credit ratings
may change over time," warned the SEC in a recent investor alert.
"The credit rating found on the official statement may not be the
credit rating of the municipal bonds if you purchase them on a subsequent
date. Investors should also be aware that, in general, credit rating agencies
are paid by the issuer whose municipal bonds they are rating."
Instead of relying on faulty and/or specious credit ratings, the SEC advises
that investors undertake their own independent review of the municipal
bonds’ risk by reading the official statement and considering its
relevant information, including the type of bond, the purpose of the financing,
the viability of any sources of revenue that will be used to pay the bonds,
and whether the bond is specified as a “non-recourse bond”
(meaning bondholders do not have a claim on underlying sources of revenue
if the bond’s particular revenue stream dries up).
“Investors need to know who is responsible for repayment of the securities
and the financial condition of that entity to assess the credit risk and
decide whether to purchase the securities,” advised the SEC in the alert.
"It is important to look beyond the short-hand label given to a municipal
bond, such as a 'general obligation bond' or 'revenue bond,'
or the bond's credit rating. Investors should read the disclosure
document, known as the 'official statement,' which provides important
details about the offering."
For additional tips on how to assess the credit risk of a municipal bond
security, access the SEC’s full investor alert here.
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