The Handbook of Municipal Bonds

CHAPTER 40

Municipal Credit Default Swaps

Frank J. Fabozzi, Ph.D., CFA, CPA Professor in the Practice of Finance Yale School of Management

 

 

 

Managers of municipal bond portfolios are experienced in how to control interest rate risk using interest rate derivative instruments. Yet, interest rate risk is only one form of risk faced by investors in the municipal bond market. The other is credit risk.

Credit risk encompasses three types of risk: (1) default risk, (2) credit spread risk, and (3) downgrade risk. Default risk is the risk that the municipal entity that issued the obligation will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of principal. Even in the absence of default, an investor is concerned that the market value of a bond will decline. Credit spread risk is the risk that the debt obligation of a municipal entity will decline due to an increase in the credit spread required by the market. Most investors in the municipal bond market commonly gauge the default risk of a municipal bond issue or municipal bond issuer by looking at the credit rating assigned by the rating agencies—Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Ratings. Once a credit rating is assigned to a debt obligation, a rating agency monitors the issuer’s credit quality and can reassign a different credit rating. Downgrade risk is the risk that the price of a municipal bond will decline due to a downgrading of the issue ...