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March 28‚ 2012
SEC Issues Investor Bulletin Regarding Municipal
Bonds
By Charles E. Carey
On March 19, the SEC’s Office of Investor Education and
Advocacy issued an Investor
Bulletin 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 obligations 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.
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