Municipal bonds are considered a conservative investment strategy. Investors buy debt obligations from government entities and in exchange receive a predetermined amount of interest payments over a specific length of time. Once the bond reaches the end of its life, known as maturing, the investor receives his initial investment back from the issuer of the bond. Despite the low-risk nature of municipal bonds, there are a few risks that potential investors should not ignore.
Inability of the Issuer to Make Payments
In some instances, the government entity that issued the bond may not be able to make payments or repay the principal once the bond has matured. Before purchasing a bond, check ratings agencies such as Standard & Poor's and Moody's Investors Services. These agencies evaluate the credit of each issuer of municipal bonds. Bonds rated as 'AAA', 'Aaa', 'BBB', or 'Baa' are considered good risks, but their offered interest rates may be lower.
To further lower the risk involved, you can also purchase a municipal bond that has insurance. These insurance policies guarantee that the principal of the loan will be repaid if the issuer defaults on the terms of the bond.
The Issuer Could Repay the Bond Early
Most municipal bonds allow the issuer to repay the principal of the bond early. The repayment can also include a premium to partially compensate the investor from the loss of income from additional interest payments. While this scenario may not be particularly worrisome, the investor will lose the interest payments as a source of income. This can be problematic for investors on a fixed income.
The Interest Rates Could Change
Most municipal bonds are issued under a fixed-rate interest plan. Therefore an investor runs the risk of purchasing a municipal bond and later watching interest rates rise. Although the investor will receive the agreed-upon rate of return, he will still lose the potential of a higher interest rate on the money he used to purchase the bond.
The Bond Could Lose Market Value
Some investors decide not to hold the bond until it reaches maturity. In these cases, investors can sell the bond, but the market will determine the value. If interest rates rise, for example, new bonds will pay a larger interest payment, or yield, than old bonds. This will make the new bonds more valuable than the old bonds. Of course, this is only a potential risk if the investor decides to sell the municipal bonds.
