The process of evaluating a municipal bond to determine its viability as an investment opportunity
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Municipal bond credit analysis involves evaluating a municipal bond to determine its viability as an investment opportunity. A municipal bond is a type of investment security that is designed to extend credit to the government or its entities. It acts as an opportunity for the government to raise funds to finance infrastructural projects such as highways, sewerage systems, railway lines, etc.
In return, the debt securities offer interest payments to the providers of credit at an agreed period, either annually or biannually. The principal amount is refunded at a future period when the bond matures. Municipal bonds are considered to come with a high-security guarantee, even though they pay lower interest rates than other investments.
Municipal bond credit analysis involves evaluating a municipal bond to determine its viability as an investment opportunity.
Municipal bonds are broadly categorized into two: general obligation bonds and revenue bonds.
The official statement of a bond provides an overview of the municipal bond, including the interest rate, name of obligor, and a feasibility study report.
Types of Municipal Bonds
Before committing to investing in a municipal bond, investors should understand the different types of municipal bonds that exist in the market, how they work, and when they can exercise a right to claim. Municipal bonds can be categorized into either general obligation bonds or revenue municipal bonds.
The bond categories carry other types of municipal bonds, each with different risk levels and values. For every type of municipal bond, repayments and principal claims can be handled either by an obligor or a revenue source. The type of municipal bond determines the terms of repayment and the rights due for a claim in the municipal bond.
1. General obligation bonds
General obligation bonds are not based on any revenue source or associated with any specific project. Most general obligation bonds are backed by tax streams from the government entity or could be associated with property owned by the entity at issuance. Other general obligation bonds are guaranteed by other unspecified revenue streams of government entities.
In such a case, potential investors must check and understand the official statements made in the issuance of the bond to understand their claim rights before they can get in a contract with the issuer. Failing to check the position of the official statement can result in a lack of claim rights in the event that the investment does not take off.
2. Revenue municipal bonds
Revenue bonds are municipal bonds that are guaranteed by revenues from the project undertaken and specified at issuance. There are different types of revenue municipal bonds, each with distinct characteristics.
For example, government entities can issue municipal bonds on behalf of non-profit schools or hospitals, where the repayments and interest payments are guaranteed by the entity from its revenue streams. In this case, potential investors should check and understand the identities of the parties involved and the state of revenue streams associated with the revenue bond before making an investment decision.
Purpose of Municipal Bond
Investors should understand the purpose of the municipal bond issuance since it can highlight probabilities of default, depending on their assessment. Investors should determine the purpose at the start to determine the risk associated with purchasing the municipal bond from the issuer.
When the obligor is the municipal entity itself, the bond is more secure than when the obligor is a conduit borrower. The official statement of the bond specifies the ultimate obligor, as well as a feasibility outlook of key assumptions made by the issuer when examining the project. Such details are key in determining the risks involved, and they guide the investor in deciding whether or not to invest in the project.
Advantage of Investing in Municipal Bonds
One advantage of municipal bonds is that the interest earned is exempted from federal income taxes, which serves as an incentive to investors. Interest payments may also be exempted from local income taxes if the lender resides in the state or locality in which the municipal bonds originated.
Although municipal bonds offer low interest, the tax exemption incentive makes them attractive to potential investors who are looking for a low-risk investment opportunity with guaranteed payments. Also, the fact that municipal bonds are backed by the government makes them even more attractive to risk-averse investors.
Alternative Payment Sources
An investor should check if there are alternative options for the bond to obtain funds that they can use to repay the interest and principal payments if the main project fails to produce expected cash flows. The alternative payment channels should be disclosed in the official statement during the issuance of the municipal bond.
Most revenue bonds disclose the alternative payment sources as a way of providing a sense of security to potential investors of the municipal bond. However, general obligation bonds may not specify the alternative channels even though they can be in existence. It is the duty of the investor to understand the characteristics of the municipal bonds and their level of security before investing in the bond.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
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