Virtually all investments involve investment risks. These risks can affect the ability of the issuer or underlying borrower (obligor) to make promised payments of principal and interest of securities held by investors, or they can affect the market value of a security when investors seek to buy and sell securities. A bond’s official statement often contains a discussion of risk factors that the issuer/obligor has identified as of the date of issuance of the securities, although additional risks may emerge over the life of the securities.
Credit/Default Risk
Credit or default risk is the risk that a bond issuer or obligor will be unable to make interest or principal payments as they become due. If the bonds have a credit enhancement, such as bond insurance, an investor may receive principal and interest payments, despite the issuer’s or obligor’s inability to provide these payments. Investors should understand the source of repayment and any conditions, legal or otherwise, that can limit the obligation to make payments or the availability of funds to make payments.
Review Credit Ratings
One way to evaluate the default risk of an issuer or obligor is to review a bond’s credit rating. A credit rating is an evaluation that rating agencies such as Standard & Poor’s, Moody’s, Fitch and Kroll Bond Rating Agency assign to a bond to indicate the likelihood that an investor will receive principal and interest payments from the issuer or obligor in a timely manner. Credit ratings represent the opinion of the rating agency and not a statement of fact or recommendation to purchase, hold or sell a security, and they can change during the life of the bond. You can find a bond’s credit rating information on MSRB’s Electronic Municipal Market Access (EMMA®) website, the official repository of municipal market data and disclosure documents. To learn more about credit ratings, see Credit Rating Basics for Municipal Bond Investors.
Assess Available Financial Information
Another way to evaluate the default risk of an issuer or obligor is to assess available financial information. This information is available in the bond’s official statement, as well as continuing disclosures state and local governments and obligors are required to provide after the initial bond sale has settled—financial/operating disclosures and event disclosures—all of which can be found on EMMA. While the official statement contains useful information on sources of payment for a bond issue, continuing disclosures provide more up-to-date information as the bond ages.
Understand Third Party Guarantees
It’s important to note that when a third party insures, guarantees or otherwise offers financial support for payments on a bond, investors need to understand the financial condition of that third party and the limitations that may exist on that support. Federal securities law requires financial professionals that buy and sell municipal bonds to have procedures in place to obtain event and other disclosures about municipal securities. Ask your investment professional if the state or local government or related agency that has issued a particular bond is current on reporting annual financial and operating data.
Interest Rate Risk
One of the principal risks facing municipal bond investors is interest rate risk, or the risk posed to a bond as a result of interest rate fluctuations. While a fixed rate bond will pay the same rate of interest throughout the bond’s life, changes in prevailing interest rates directly affect the market value of a bond. Interest rates and bond prices have an inverse relationship, so if market interest rates rise, the price of a bond will fall and vice versa. Moreover, the longer the time to maturity of a bond, the more sensitive the bond will be to changes in interest rates.
Selling Before Maturity
If an investor holds the bond to maturity, they will receive the principal assuming the issuer is able to pay. However, if the investor sells a bond prior to maturity, the investor may receive a price that is different from the original purchase price and as a result receive more or less than the amount invested. To learn more, see The Impact of Market Interest Rate Movement on Municipal Bond Prices and Yields.
Call Risk
Call risk is the risk that a callable bond may be redeemed by the issuer or obligor prior to maturity. If a bond is called, the investor will lose the ability to collect interest from the time the bond is redeemed to the scheduled date of maturity, thus reducing the investor’s overall return on the bond. Bonds are often called by issuers or obligors in a declining interest rate environment, so that the issuer or obligor may refinance outstanding bonds at a lower interest rate in what is known as a refunding transaction. See Possible Redemption of Build America Bonds as an example of a refunding transaction.
Reinvestment Risk
Reinvestment risk is the risk an investor may not be able to reinvest the proceeds received at a bond’s maturity or call date at the same or higher rate than that at which the investor initially invested its funds.
Liquidity Risk
Liquidity risk is the risk that there may not be a significant market for the purchase and sale of a bond. Liquidity risk may generally be greater for:
- Lower-rated bonds
- Bonds that were part of a small issue
- Bonds that have recently had their credit ratings downgraded, or
- Bonds sold by an infrequent issuer, among other factors.
More liquid bonds are typically those that have a large trading volume and many dealers that routinely buy and sell such bonds. In general, greater liquidity enhances the market value of the bond. The converse is also true. The more illiquid a bond, the more likely the bond will have a lower price in the secondary market and there may be fewer bids for the bonds.
Legislative Risk
Legislative risk is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. Unanticipated changes in taxation may adversely impact the value of a bond to its investors and consequently affect its market value.
