Municipal Bonds – Part One

Municipal bonds come in the following two varieties:

  • general obligation bonds
  • revenue bonds

General obligation bonds, issued to raise immediate capital to cover expenses, are supported by the taxing power of the issuer. Revenue bonds, which are issued to fund infrastructure projects, are supported by the income generated by those projects. Both types of bonds are tax exempt and particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts.

Risk Factors
While buying municipals bonds is viewed as a conservative investment strategy, it is not risk-free. The following are the risk factors:

Credit Risk: If the issuer is unable to meets its financial obligations, it may fail to make scheduled interest payments and/or be unable to repay the principal upon maturity. To assist in the evaluation of an issuer’s creditworthiness, ratings agencies (such as Moody’s Investors Service and Standard & Poor’s), analyze a bond issuer’s ability to meet its debt obligations, and issue ratings from ‘Aaa’ or ‘AAA’ for the most creditworthy issuers to ‘Ca’, ‘C’, ‘D’, ‘DDD’, ‘DD’ or ‘D’ for those in default. Bonds rated ‘BBB’, ‘Baa’ or better are generally considered appropriate investments when capital preservation is the primary objective. To reduce investor concern, many municipal bonds are backed by insurance policies guaranteeing repayment in the event of default.

Interest-Rate Risk
: The interest rate of most municipal bonds is paid at a fixed rate. The rate does not change over the life of the bond. If interest rates in the marketplace rise, the bond you own will be paying a lower yield relative to the yield offered by newly issued bonds.

 

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