With these improvements, fraud levels within the muni market have come down, but investors should still take simple precautions to avoid potential problematic areas.

In this article, we’ll look at some of the regulations on the muni bond market and how investors can take extra steps to ensure their protection.

The municipal bond market is governed by the Municipal Securities Rulemaking Board (MSRB), which defines the relationship that governments have with financial professionals and plays a role in helping state and local governments communicate with investors. Many new regulations were implemented after the Dodd-Frank Wall Street Reform (check here) and the Consumer Protection Act was enacted based on the Dodd-Frank reforms to prevent fraud and eliminate conflicts of interest across financial services. Read this article to learn more about how the municipal bond market operates and the relationships between investors and intermediaries.

Intermediary Obligations

State or local governments that issue municipal bonds often rely on an underwriter to help bring the bond to market and a financial advisor to provide advice before and after issuing the bond. These underwriters and advisors must be registered with the MSRB and are required to provide accurate information related to the sale of bonds.

Financial advisors, underwriters, broker/dealers, ratings agencies, issuers and insurers are also bound by a fiduciary duty to their state or local government issuer clients. Rather than simply turning a blind eye to potential concerns, these clauses make every part of the bond issuance process liable for mistakes that should have been caught.

Consider this. Barclays Capital Inc. was fined $500,000 for failing to conduct adequate due diligence by not having a reasonable basis for believing the truthfulness of certain official statements. Similarly, TD Securities USA LLC was fined for selling securities based on materially misleading disclosure documents.

Issuer Obligations

Besides providing regular disclosures on MSRB, issuers are encouraged to adhere to guidelines set forth by the Government Finance Officers Association (GFOA) and the National Federation of Municipal Analysts (NFMA). These organizations provide recommended best practices for disclosures related to specific kinds of muni bond offerings, such as charter schools or general obligation bonds. Check here to keep informed with the latest updates from NFMA.

In the past, SEC focused on prosecuting the bond counsel, underwriters or attorneys involved with the issuance of bonds. But recently, it has settled cases with states, restricted the ability to issue bonds and exacted financial penalties from individual officials to make it clear that issuers must take a more active role in maintaining standards.

For instance, Ohio State University and the Delaware Transportation Authority were included in the recipients of over 70 fines issued to municipalities issuing bonds for failures to provide investors with sufficient disclosures. The settlements in these cases required the parties to reform their policies, procedures and staff training related to these obligations and update past filings, among other things. To know more about muni bonds from Ohio and Delaware, click here and here. Also, have a look at our Market Activity section to keep track of the latest muni bond trades.

Apart from considering the various macroeconomic factors (learn more here) that might affect a muni bond’s value, investors should be aware of the key areas of the prospectus to identify problematic areas.

• Revenue source: A bond’s source of revenue is perhaps the most important consideration when it comes to assessing risk. For example, a revenue bond backed by parking revenue may be inherently much riskier than a government backed general obligation bond.

• Financial statements: A municipality’s financial statements can provide great insights into underlying credit quality. For example, calculating the debt coverage ratio (the ratio of cash available for debt servicing to interest and principal) can help an investor determine the likelihood of a municipality to repay its debt if it were to run into unexpected trouble.

• Interest rate determination process: A bond’s interest rate determination process (eg. discounting rate used in the present value calculations) can be helpful in determining whether an interest rate is fairly set. Investors should look at a bond’s potential yield and ensure that it aligns with their own return expectations.

• Redemption provisions: Redemption provisions could impact the value of a bond. For example, a callable bond could throw of an investor’s bond ladder by prematurely reducing future interest payments and altering a portfolio’s duration.

• Credit enhancement clauses: Credit enhancement and liquidity support clauses – such as bond insurance – can reduce the inherent credit risk.

• Legal rights: Legal issues surrounding a bond or issuer could present future challenges to investors, particularly if there’s a default. Investors should be aware of their rights, if a default were to occur, along with other special bond provisions like callability, refunding and variable rates (if any) – all of which can have a significant impact on a bond’s valuation over time.

• Consultant reports: Independent consultants can be extremely helpful in determining if a bond’s underlying project is feasible.

• Bookkeeping procedures: Bookkeeping procedures are helpful when looking at how a bond’s finances are handled throughout its lifespan. In some cases, it is useful to be aware of how special provisions are accounted for. For instance, a sinking fund or escrow account can be set up by the issuer to set money aside for debt repayment.

Regulatory authorities have created a framework for muni bond investors to make informed investment decision. Besides, investors should be aware of their rights in the event of a default – or other adverse credit event – and know what factors to look for in a prospectus to quantify risk.

To familiarize with various concepts within the muni bond market, visit Municipal Bonds’ Education section.