A:

Municipal bonds offered as debt securities from states, cities and other municipalities offer investors an opportunity to add a degree of safety and diversification to a portfolio. A muni bond is used to raise funds for the municipality issuing the security, generally for community projects such as school repair or construction, road repairs, or new highway construction. This investment option has long been thought of as a conservative position because, instead of being backed by a higher risk corporation, there is an assumption that the municipality offering the bond is held to a higher standard of risk and cash reserve management. Although default is not a common occurrence with municipal bond issues, investors are wise to evaluate the issuer's financial position prior to buying its bond.

Debt Service Coverage Ratio

For novice and experienced investors, assessing the financial strength of a municipality issuing a bond is an important step in understanding the potential for default of the issue. While general obligation municipal bonds are analyzed through a review of an issue's credit rating, revenue bonds can be analyzed using the debt service coverage ratio (DSCR). This calculation shows investors the number of times a municipality is able to pay both the principal and interest payments on a bond with the cash that is set aside for those payments. For instance, a municipality with a cash balance of $10 million available to cover debt payments and $2.5 million in total principal and interest payments due in that year would yield a DSCR of 4 ($10 million / $2.5 million = 4). Higher ratios indicate greater safety, but investors consider a ratio of 2 or greater to be acceptable.

Although municipal bonds boast less risk than equity positions or high yield corporate bonds, it is necessary to evaluate the financial stability of the issuing municipality. Credit ratings can be used to assess risk for general obligation bonds while the DSCR is used to determine degree of safety for revenue bonds.

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