Investment Risk

Virtually all investments involve investment risks. Risks can affect the ability of the issuer 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. 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. When a third party insures, guarantees or otherwise offers financial support for payments on securities, investors need to understand the financial condition of that third party and the limitations that may exist on that support. The official statement often contains a discussion of risk factors that the issuer has identified as of the date of issuance of the securities, although additional risks may emerge over the life of the securities.

Credit Rating
A municipal security’s credit rating is the grade a rating agency assigns to indicate the risk of default. Ratings are intended to measure the probability of the timely repayment of principal for and interest on municipal securities and represent the opinion of the rating agency and not a statement of fact or recommendation to purchase, hold or sell a security. Municipal securities can receive a rating at the time of issuance or at any time over the life of the security, and such rating may be changed or withdrawn at any time. There are no requirements for municipal securities to be rated or, if a security has received a rating, to be rated by all rating agencies.

Multiple ratings may be assigned to a municipal security by a single rating agency. Typically, a bond will receive a “long-term” rating, which reflects the rating agency’s opinion about the overall risk of default for the municipal security, taking into account the effect of any credit enhancement features, such as bond insurance or other forms of third party guarantee or support. In the case of some notes or other short-term obligations, the rating agency may instead assign a “short-term” rating reflecting the rating agency’s opinion concerning the risk of default on maturing payments. In the case of a long-term obligation that has certain short-term tender/put features, a short-term rating may reflect the rating agency’s opinion concerning liquidity risks associated with the short-term feature. Further, if the municipal security’s rating is based on any credit enhancement features, the rating agency may also assign an “underlying” or “unenhanced” rating expressing an opinion on the credit quality of a municipal security independent of any credit enhancement features.

Legislative Risk
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 will affect its immediate market value. Legislative risk is the term used to describe this risk, such as the risk that a change in the tax code could affect the value of a taxable or tax-exempt interest income. Without the value of tax exemption, an investor in a tax-exempt bond will receive a significantly lower yield on the securities than initially expected.

Default Risk
The risk that a bond issuer will be unable to make interest or principal payments as they become due. If the bonds have a credit enhancement however, an investor may nonetheless receive its full principal and interest payments as they become due notwithstanding the issuer’s inability to provide these payments.

Call Risk
The risk that a callable bond may be redeemed by the issuer prior to maturity. If a bond is called, the investor will lose the ability to collect interest from the time of the redemption to the bond’s scheduled date of maturity, thus reducing the investor’s over all return on investment. Additionally, bonds are often called by issuers in a declining interest rate environment, so that the issuer may refinance the bonds at a lower interest rate. In a declining interest rate environment, an investor may not be able to reinvest the proceeds received as a result of the redemption at the same rate at which the investor initially invested its funds.

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. In general, the longer the maturity of a bond, the greater the risk. If a bond is sold prior to its maturity in any interest rate environment, whether rates are high or low, its price or market value will likely be affected by the prevailing interest rates at the time of the sale. When interest rates rise, investors attempting to sell a fixed rate bond may not receive the full par value. When interest rates fall, the same investors may receive more than the par value in a secondary market sale. “Duration” permits an investor to estimate how much a bond’s price may rise or fall depending on movements in interest rates. Read more about evaluating a bond’s interest rate risk.

Liquidity Risk
Liquidity risk is the risk that there may not be a significant market for the purchase and sale of the bonds. 

Risks of Selling a Bond before Maturity
While investors in municipal bonds often are “buy and hold” investors — that is, they intend to own bonds as long-term investments to be held to maturity — investors may wish or need to sell their bonds prior to their stated maturity. There are risks and costs associated with selling a municipal bond prior to maturity. Investors should understand these risks and costs when considering the purchase and sale of municipal bonds. Read an overview of these considerations.