Municipal Bonds: Understanding Credit Risk

INVESTOR BULLETIN Municipal Bonds: Understanding Credit Risk The SEC’s Office of Investor Education and Advocacy is issuing this Investor Bulletin to help educate investors about assessing credit risks they face when purchasing municipal bonds, which may also be called notes or certificates of participation. Credit risk—or default risk— is the risk that interest and/or principal on the securities will not be paid on time and in full. 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. It is important to look beyond the short-hand label given to a municipal bond, such as “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, including the factors described below. What are Municipal Bonds? Municipal bonds are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways or sewer systems. By purchasing municipal bonds, you are in effect lending money to the issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment—or principal. The entity responsible for repaying the principal and interest on the bonds may be the issuer, or an underly- ing borrower, known as the obligor or “obligated person.” Obligors could be another governmental entity, a for-profit firm, or a non-profit entity. The date on which the principal is scheduled to be repaid, known as the security’s maturity date, may be years in the future. Generally, the interest on municipal bonds is exempt from federal income tax. The interest may also be exempt from state and local taxes if you reside in the state where the bond is issued or if issued by a U.S. territory, such as Puerto Rico. Given the tax benefits, the interest on municipal bonds is usually lower than on taxable fixed-income securities such as corporate bonds. Factors investors should consider when assessing the credit risk of municipal bonds: 1. Types of Municipal Bonds The type of municipal bond issued affects both the risk of default and the value of the municipal bond. Repay- ment may come from the issuer, an obligor, or from a single tax or revenue source. There are two major types of municipal bonds: “general obligation bonds” and Investor Assistance (800) 732-0330 www.investor.gov “revenue bonds.” Because these types come in many varieties, you should look beyond the short-hand label when deciding whether to purchase. n General obligation bonds are issued by govern- mental entities and are not backed by revenues from a specific project or source. Some general obligation bonds are backed by dedicated taxes on real property and, on occasion, other taxes. Other general obligation bonds are payable from general funds and are often referred to as backed by the “full faith and credit” of the governmental entity. While in many instances “general obligation” means that the issuer or other governmental entity responsible for repaying the bonds...

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