On March 19, the SEC's Office of Investor Education and Advocacy issued an Investor Bulletin http://www.sec.gov/investor/alerts/municipalbonds.htm to help educate individual investors about municipal bonds.
While the Investor Bulletin is fairly basic and addressed primarily to investors generally, the list of some of the risks of investing in municipal bonds included in the Bulletin may be helpful to issuers and underwriters when preparing or reviewing disclosure documents. The risks highlighted in the Bulletin (and a few additional thoughts) are outlined below:
Call risk. Call risk refers to the potential for an issuer to repay a bond before its maturity date. (It should be noted that in addition to the "call" provisions which might apply to the obligations being offered for certain types of obligations, investors may also be interested in information as to past call practices of the issuer.)
Credit risk. This is the risk that the bond issuer may experience financial problems that make it difficult or impossible to pay interest and principal in full. (Credit ratings are of course available for many bonds, and used by many individuals as a proxy for their own credit analysis; however, in light of the recent problems with "rated" mortgage-backed and asset-backed obligations, an increasing number of investors are attempting to look through the credit ratings and make their own determination of credit risk.)
Interest rate risk. A bond's market price will move up as interest rates move down and it will decline as interest rates rise, so that the market value of the bond may be more or less than its par value. U.S. interest rates have been low for some time. If they move higher, investors who hold a low fixed-rate municipal bond and try to sell it before it matures could lose money because of the lower market value of the bond.
Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. It also can lead to higher interest rates and, in turn, lower market value for existing bonds.
Liquidity risk. This refers to the risk that investors won't find an active market for the municipal bond, potentially preventing them from buying or selling when they want and obtaining a predicable price for the bond. Many investors buy municipal bonds to hold them rather than to trade them, so the market for a particular bond may not be especially liquid and quoted prices for the same bond may differ.
Change in tax law risk. While not included in the Bulletin's list of risks, discussions in Washington as to the possible repeal or limitation of the exclusion of interest on municipal obligations are raising concerns in the municipal markets. Changes in the tax treatment of municipal obligation will have an immediate effect on market values of affected obligations.
The Investor Bulletin is clearly intended as fundamental guidance to investors. The list of risks included in the Investor Bulletin is by no means comprehensive and not necessarily a list of risks that should be disclosed in offering documents. However, the list does highlight factors the SEC believes are important to investors and similar disclosures have become fairly routine in corporate and mutual fund risk disclosure sections.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
