A Corporate Bond Rated Aaa or a Municipal Bond Rated Aaa
In particular, a corporate bond rated Aaa has a higher likelihood of bearing a higher interest rate (yield) compared to a municipal bond having a rate Aaa. The main reason for the high-interest rate on corporate bonds is because they are significantly risky. Corporate bonds are vulnerable to numerous risks, such as interest rate risk, call risk, inflation risk, liquidity risk, and credit risk (Investor.gov, n.d.). As a result of the various risks, investors ask for higher interests to compensate for the risks. The request for a higher interest rate is based on the assumption that increased risks ought to be compensated by higher returns to lenders (Mikesell, 2013). As such, lenders who are inclined to a higher interest rate will go for corporate bonds. Despite the higher interest rate, they also have to contend with increased risk for default among private corporations.
On the other hand, interest rates are lower for municipal bonds because government-issued bonds have a low risk of default. It should be noted that municipal bonds are offered by counties, states, cities, and other forms of local governments (Investor.gov, n.d.). In the US, credit risks for bonds issued by local authorities are low (Mikesell, 2013). However, on rare occasions of default, they are usually associated with a significant economic recession, unresolved political disputes, or flagrant fiscal mismanagement. Moreover, since capital markets keep credit histories, governments make an effort to prevent earning a reputation that damages their credit rating to access loans in the future (Mikesell, 2013). This incentive makes governments avoid missing scheduled debt service. Besides, defaults result in a poor credit rating, which increases the interest rate for bonds. Don't use plagiarised sources.Get your custom essay just from $11/page
For this reason, municipalities have a significant economic stimulus to maintain a good credit rating (Mikesell, 2013). Lenders who are risk-averse are likely to favor municipal because they have a guaranteed return.
3(b). A Municipal Bond Rated Baa or a Municipal Bond Rated Aa
In this case, a municipal bond rated Baa will command a high-interest yield compared to a municipal bond having an Aa rating. The main reason for the high-interest rate in the latter is because it is considered to have a high credit risk, which demands an increased rate of return as compensation for the heightened credit risk. Base on Mergent’s credit rating, a Baa credit standard is classified as a medium grade (Mikesell, 2013). A bond with a credit rating of this grade is neither sufficiently protected nor poorly secured. Often, such bonds have adequate present security but have a higher likelihood of being unreliable over any substantial length of time. It is worth noting that bonds with Baa rating perform poorly in the market because lenders shy away from them due to the high credit risk. Only lenders who have are more concerned about returns interest rates are likely to acquire such bonds.
On the other hand, a municipal bond bearing an Aa rating has a low-interest rate because it is perceived to have a low credit risk. Mergent’s credit rating categorizes an Aa credit rating as high quality (Mikesell, 2013). This form of rating implies that a municipal bond of an Aa rate has a relatively small margin of protection or comparatively more significant fluctuation of protective factors compared to an Aaa (Mikesell, 2013). As such, the high credit quality for a municipal bond rated Aa explains why it has a lower interest rate compared to a municipal bond with Baa rating.
3(c). A General Obligation Bond Issued by a City or a Revenue Bond Issued by a City
While the two types of bonds have relatively high credit ratings, a revenue bond offered by a city will have a slightly higher interest yield compared to the latter. The main reason for the relatively high-interest rate is because the repayment of such bonds is pegged on specified revenue streams, which might be affected by unforeseen risks such as bad weather and economic downturns. As Hackworth (2014) explains, revenue bonds are often repaid using a specific revenue stream such as airport user fees or electricity remittance. However, even though pre-specified streams of revenue back revenue bonds, they are perceived as riskier compared to general obligation bonds. If a project is unsuccessful or fails to generate adequate income, the municipal government has no other option of repaying holders of bonds (Motley Fool Staff, 2016).
Moreover, revenue streams may be affected by unforeseen eventualities, which may result in defaults, thus lengthening the repayment period of bonds. For instance, Washington Public Power Supply System bonds experienced a permanent default (Mikesell, 2013). For this reason, revenue bonds are likely to attract a higher interest yield in comparison to general obligation bonds.
Notably, a general obligation bond offered by a city has a low-interest rate because of its high credit rating quality. While there is no risk-free investment, this form of bond can be considered to be almost without risk. According to Hackworth (2014), general obligation bonds are secured/backed with the “full faith and credit” of the tax base of a municipality. The tax base serves as collateral because a majority of states prohibit local authorities from using their physical property, such as equipment and real estate for collateral purposes. Due to this condition, numerous states stipulate that cities and counties must hold a formal referendum to issue general obligation bonds (Hackworth, 2014). The high level of commitment indicates that general obligation bonds are increasingly secure, thus attracting low-interest rates.
3(d). A General Obligation Bond Rated Aa Issued by a City or a General Obligation Bond Rated Aa Issued by a County
In particular, both of the two bonds will attract the same interest rate because of their similarity. The two bonds have a low-interest yield because they are highly secured. Hackworth (2014) opines that general obligation bonds are secured/backed with the “full faith and credit” of the tax base of a municipality. The fact that they are different in that one is offered by a city, and another one is issued by a county does not affect the terms of their issuance.
Moreover, the two bonds have the same credit rating of Aa, which implies that they have an identical credit quality. Lenders will be indifferent when selecting the two forms of bonds since they have the same interest rates and risks.
3(e). A Municipal Bond (term) with Maturity in Five Years or a Municipal Bond (term) with Maturity in Twenty Years
While municipal bonds generally have low-interest rates, a municipal bond that matures after 20 years is likely to have a higher interest yield compared to a similar bond that matures in five years. The high-interest rate is caused by the fact that a more extended maturity period increases the risks of default, such as call risks, credit risks, interest rate risks, inflation risks, and liquidity risks (Investor.gov, n.d.). Under call risks, the issuer of a municipal bond may opt to repay a bond before its date of maturity, especially if there is a fall in interest rates. Moreover, a longer maturity period is profoundly affected by inflation, resulting in higher interest rates. As such, a municipal bond that matures in 20 years is likely to have a higher interest rate owing to increased risks.
On the other hand, a municipal bond with a maturity of five years is less likely to have a high-interest rate due to a decrease in risks. Risks such as inflation, credit, and call risk are reduced when a maturity period is five years. Moreover, a municipal bond with a shorter maturity is attractive to lenders due to a reduction in risks.
References
Hackworth, J. (2014). The neoliberal city: Governance, ideology, and development in American Urbanism. Ithaca, NY: Cornell University Press.
Investor.gov. (n.d.). Municipal bonds. Retrieved from https://www.investor.gov/introduction-investing/basics/investment-products/municipal-bonds
Mikesell, J. L. (2013). Fiscal administration (9th ed.). Boston, MA: Cengage Learning.
Motley Fool Staff. (2016, July 13). What are general obligation bonds? Retrieved from https://www.fool.com/knowledge-center/what-are-general-obligation-bonds.aspx