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 recommendation.
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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