Many states, cities, and counties issue municipal bonds. These municipalities issue debt to pay for capital projects and to fund general operations. For some taxpayers, interest earned on municipal bonds may be tax-exempt. Bonds are rated, based on their ability to repay principal and interest payments on time. Understanding a bond’s rating helps an investor evaluate the risk of buying a bond.
Why investors buy municipal bonds
A bond indenture is the legal document that explains the rights of the bond owner and the responsibilities of the bond issuer. The indenture requires the issuer to pay interest to the owner, usually semi-annually. Bond issuers must also repay the principal amount invested on the maturity date.
Investors buy bonds primarily for the predictable interest payments each year. While a municipal bond’s price may change, bond buyers expect to receive the principal amount at maturity. Many investors reinvest the principal payment in new municipal bond purchases. Timely payment of principal and interest is important. If a bond does not pay principal or interest on a timely basis, the bond is said to be in default.
Understanding municipal bond ratings
Bond ratings assess the ability of a municipal bond issuer to repay principal and interest on a timely basis. This assessment of creditworthiness affects the interest rate offered to investors. Bond with higher credit ratings can offer a lower interest rate – and still attract investors. Here are the three ratings agencies for municipal bonds:
- Standard and Poor’s: Standard and Poor’s (S and P) describes a bond rating as the ability of an issuer to meet its “financial obligations in full and on time.” S and P defines the bonds with highest creditworthiness as investment grade. These securities have ratings of AAA (highest) down to BBB-. Bonds rated BB+ and lower are speculative grade.
- Moody’s: Moodys also provides bond ratings using letters to designate creditworthiness. You may also notice ratings companies referring to creditworthiness as the risk of default. The highest Moodys rating is Aaa. The ratings decline from Aa to A to Baa. Baa is considered medium grade with some speculation. Bonds rated below Baa are considered to be speculative.
- Fitch: Fitch rates investment grade securities with a bond rating from AAA down to BBB. BB down to D are considered to be speculative bonds.
Bond purchasers should consider the creditworthiness of municipal bonds by reviewing the bond rating. While the rating does not guarantee repayment, it does reflect the opinion of analysts who specialise in municipal bonds. A financial professional can provide a more detailed understanding of municipal bonds ratings and whether of not municipal bonds are suitable for your investment goals.