Municipal Bond Basics

Bond ratings can be modified with a plus or minus or a number to indicate relative standing within that letter grade. For example, Aa1 would be only one notch below Moody's highest rating, while BBB- would mean that S&P considers a bond only one step from not having an investment-grade rating.

Investments seeking to achieve higher returns also involve a higher degree of risk.

Munis and Credit Quality

Bond Credit Quality Ratings

	S&P	Moody's	Fitch
INVESTMENT GRADE
Highest quality; minimal credit risk	AAA	Aaa	AAA
High quality; very low credit risk	AA	Aa	AA
Good quality; low credit risk	A	A	A
Moderate credit risk; may be vulnerable to changes in economic conditions	BBB	Baa	BBB
NOT INVESTMENT GRADE
Facing uncertainties; substantial credit risk	BB	Ba	BB
Speculative; has ability to pay debts but is vulnerable	B	B	B
Dependent on favorable conditions to meet payments; very high credit risk	CCC	Caa	CCC
Highly speculative and vulnerable to nonpayment	CC	Ca	CC
Bankruptcy petition filed, but payments being made (S&P); in default (Moody's)	C	C	C
In default	D	C	D

Just as individuals have credit ratings, bonds also have credit ratings that represent a way to gauge the likelihood that the debt will be repaid. Bonds are rated for their creditworthiness by an independent rating agency, which issues a letter grade that indicates its opinion of the bond's quality. (Some bonds are ungraded, not necessarily because they are unsound investments but because the bond issuer feels the offering is too small to justify the cost of having it rated.)

Issuers of investment-grade bonds are considered likely to make all payments in full and on time. By contrast, bonds that are less than investment grade are seen as at least somewhat speculative. Because of that greater risk, such bonds generally must pay a higher yield to attract investors.

The three primary bond rating agencies--Standard & Poor's, Moody's, and Fitch--use slightly different designations, but the systems are somewhat comparable. The rating agencies may upgrade or downgrade the credit rating of a bond issuer at any time. They may also issue a negative outlook, indicating that the rating agency believes there is a strong possibility of a downgrade in the future.

Bond issuers pay the cost of obtaining a bond rating, but since the 2008 financial crisis, the Securities and Exchange Commission has taken steps to try to ensure that rating agencies do not have a conflict of interest and that ratings are objective and consistently reliable over time.

In the past, municipal bond defaults have been comparatively rare compared with corporate bonds. However, they're by no means impossible, as the 2012 bankruptcies of several California local governments made clear, and it's important to remember that past performance is no guarantee of future results.

Financial pressures coupled with low tax revenues during economic hard times and taxpayer opposition to tax increases could ultimately affect the security of municipal bond payments by particularly hard-hit state and local governments. However, problems in one region do not necessarily affect all municipal issuers.

That's why it's important to ensure that you are aware of the risk-reward ratio and credit rating of any muni you're contemplating. And though diversification can't guarantee a profit or insure against the possibility of loss, you may be able to use it to spread your risk among not only various governmental entities but also different types of munis with varying credit quality ratings and yields.