INVESTOR BULLETIN

Municipal Bonds: 

Understanding Credit Risk

The SEC’s Office of Investor Education and Advocacy is 

issuing this Investor Bulletin to help educate investors 

about assessing credit risks they face when purchasing 

municipal bonds, which may also be called notes or 

certificates of participation. Credit risk—or default risk—

is the risk that interest and/or principal on the securities 

will not be paid on time and in full. Investors need to 

know who is responsible for repayment of the securities and 

the financial condition of that entity to assess the credit risk 

and decide whether to purchase the securities. It is important 

to look beyond the short-hand label given to a municipal 

bond, such as “general obligation bond” or “revenue bond,” 

or the bond’s credit rating. Investors should read the 

disclosure document, known as the “official statement,” 

which provides important details about the offering, 

including the factors described below. 

What are Municipal Bonds?

Municipal bonds are debt securities issued by states, 

cities, counties and other governmental entities to fund 

day-to-day obligations and to finance capital projects 

such as building schools, highways or sewer systems. 

By purchasing municipal bonds, you are in effect 

lending money to the issuer in exchange for a promise 

of regular interest payments, usually semi-annually, and 

the return of the original investment—or principal. 

The entity responsible for repaying the principal and 

interest on the bonds may be the issuer, or an underlying borrower, known as the obligor or “obligated 

person.” Obligors could be another governmental 

entity, a for-profit firm, or a non-profit entity. The 

date on which the principal is scheduled to be repaid, 

known as the security’s maturity date, may be years in 

the future. 

Generally, the interest on municipal bonds is exempt 

from federal income tax. The interest may also be 

exempt from state and local taxes if you reside in the 

state where the bond is issued or if issued by a U.S. 

territory, such as Puerto Rico. Given the tax benefits, 

the interest on municipal bonds is usually lower than 

on taxable fixed-income securities such as corporate 

bonds.

Factors investors should consider 

when assessing the credit risk of 

municipal bonds:

1. Types of Municipal Bonds

The type of municipal bond issued affects both the risk 

of default and the value of the municipal bond. Repayment may come from the issuer, an obligor, or from a 

single tax or revenue source. There are two major types 

of municipal bonds: “general obligation bonds” and 

Investor Assistance (800) 732-0330 www.investor.gov
“revenue bonds.” Because these types come in many 

varieties, you should look beyond the short-hand label 

when deciding whether to purchase. 

n General obligation bonds are issued by governmental entities and are not backed by revenues from a 

specific project or source. Some general obligation 

bonds are backed by dedicated taxes on real property 

and, on occasion, other taxes. Other general obligation 

bonds are payable from general funds and are often 

referred to as backed by the “full faith and credit” of 

the governmental entity. While in many instances 

“general obligation” means that the issuer or other 

governmental entity responsible for repaying the 

bonds has the unlimited authority to tax residents to 

pay bondholders, in other cases, the issuer or other 

governmental entity may have limited or no taxing 

authority. Investors should carefully read the official 

statement describing the general obligation bond 

before making an investment decision.

n Revenue bonds are backed by revenues from a 

specific project or source. There is a wide diversity 

of types of revenue bonds, each with unique credit 

characteristics. For example, municipal entities 

frequently issue securities on behalf of other 

borrowers such as non-profit colleges or hospitals 

or certain for-profit entities. These underlying 

“conduit” borrowers typically agree to repay the 

issuer, who pays the interest and principal on the 

securities solely from the “revenue” provided by the 

conduit borrower. Investors should carefully read 

the official statement describing the revenue 

bond, and understand both the identity of the 

conduit borrower, if any, and what revenues are 

actually pledged to back the bonds, before making 

an investment decision.

2. Non-Recourse Financings 

Some revenue bonds are “non-recourse,” meaning that 

if the revenue stream dries up, or if payments on the 

bonds are otherwise not paid, the bondholders do not 

have a claim on the underlying revenue source or 

against the conduit borrower. In instances where a 

conduit borrower fails to make a payment to the 

municipal issuer, the issuer is usually not required to 

pay the bondholders. For these reasons, it is essential to 

understand the source of the revenues that will be used 

to repay the bonds. 

3. Purpose of the Financing 

Municipal bond default rates vary considerably depending on a variety of factors, including the types of bonds 

issued and whether the ultimate obligor is a municipal 

entity or a non-municipal entity (i.e., a conduit borrower). For example, if you are considering purchasing 

municipal securities that finance speculative projects, 

including those involving for-profit businesses, pay 

close attention to the potential risks involved. The 

official statement for this kind of offering usually will 

include a feasibility study showing the key assumptions 

made in evaluating the project. Understanding those 

assumptions can help you evaluate the risks. 

4. Financial Condition of the Issuer or 

Other Obligor 

A key concern is whether the issuer or other obligor 

will be able to pay interest and principal in full. To 

evaluate the financial condition of the issuer or other 

obligor, consider (among other things): 

n Debt and other longer-term liabilities payable from 

or impacting the same source of revenue as the bonds, 

including, if applicable, pension and other postemployment benefit obligations of the municipal 

bond issuer;

Investor Assistance (800) 732-0330 www.investor.gov

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Investor Assistance (800) 732-0330 www.investor.gov

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n The underlying local economy, including employment, income, wealth, and tax burden; and

n The audited financial statements of the issuer or 

obligor, including both revenues and expenses.

5. Other Sources of Funds to Pay 

Principal and Interest 

While some municipal bonds are general obligation 

bonds, others are repaid not by an issuer or other 

obligor, but from a specific payment stream. You 

should evaluate the viability of the sources of revenue 

to be used to make these payments. In evaluating the 

source of payment for the bonds, you should consider 

(among other things): 

n Economic or social trends that may limit demand for 

particular goods or services (such as gasoline or 

cigarettes) when those goods or services are being 

taxed to fund the repayment of the securities; and

n Statutory limits on raising revenues, such as the need 

for voter approval.

What are Credit Ratings?

While some investors find it helpful to consider credit 

ratings when making an investment decision, it is 

important that you not rely solely on credit ratings 

when deciding whether to purchase municipal bonds. 

Investors need to undertake their own independent 

review of the municipal bonds’ risk by reading the 

official statement and other relevant information 

described below.

Credit ratings are assessments of municipal bonds’ 

credit risk at a particular point in time. You should be 

aware that because credit ratings may change over time, 

the credit rating found on the official statement may 

not be the credit rating of the municipal bonds if you 

purchase them on a subsequent date. Investors should 

also be aware that, in general, credit rating agencies are 

paid by the issuer whose municipal bonds they are rating.

Credit ratings are only assessments by credit rating 

agencies of the credit risk associated with a municipal 

bond. Each credit rating agency evaluates credit risk 

based on its own standards, applies its own ratings 

methodology, and weighs the various factors in the 

methodology differently. Credit ratings are not investment advice, guarantees of credit quality or of future 

credit risk, or indications that an investment is suitable. 

They are designed to address only one aspect of an 

investment decision—credit risk. As an investor, you 

may or may not agree with the credit rating. 

Where should I look for information 

regarding municipal securities?

In most cases, official statements as well as updated 

information regarding the issuer and the municipal 

bonds can be found on the Electronic Municipal 

Market Access (EMMA) website, www.emma.msrb.org. 

The issuer’s financial information is often updated each 

year. In addition, many municipal bond issuers provide 

“material event notices” that contain information 

concerning, among other things, delinquent principal 

and interest payments, other types of defaults, rating 

changes, events impacting the tax status of the securities, 

and bond redemptions or calls. EMMA also has some 

credit ratings information. 

Often, the official statement contains a section titled 

“investment risk factors” or “investment considerations,” which provides information relevant to your 

investment decision. In addition, pertinent financial 

information regarding the issuer generally may be 

found in an appendix attached to the official statement.

This publication focuses on credit risk. Investments in 

municipal bonds entail other risks, such as call risk, 

interest rate risk, inflation risk, and liquidity risk. 

Please refer to the material listed below for more 

information on these risks.
Investor Bulletin: Municipal Bonds (available at 

http://www.sec.gov/investor/alerts/municipalbonds.htm)

FINRA and MSRB Investor Alert: Municipal 

Bonds—Staying on the Safe Side of the Street in 

Rough Times (available at http://www.finra.org/

investors/protectyourself/investoralerts/bonds/

p118923)

Related Information The Office of Investor Education and Advocacy 

has provided this information as a service to 

investors. It is neither a legal interpretation nor 

a statement of SEC policy. If you have questions concerning the meaning or application 

of a particular law or rule, please consult with 

an attorney who specializes in securities law.

SEC Pub. No. 134 (12/12)