Tax free bonds, also known as municipal bonds, pay a fixed interest rate and are exempt from federal taxation. Municipalities that issue the bonds guarantee that investors will receive their scheduled interest payments and the return of the original principal. The strength of the guarantee depends on the financial health of the municipality issuing a bond. Ratings agencies Moody’s, Standard & Poor’s, and Fitch assign each tax free bond a credit rating based on the issuing municipality's financial information and the likelihood of default.
High-Grade Tax Free Bond Ratings
The highest quality tax free bonds are rated Aaa by Moody’s, and AAA by Standard & Poor’s and Fitch. These municipalities have the strongest financials and are the least likely to default on their obligations. High quality bonds are rated Aa1 by Moody’s, and AA+ by Standard & Poor’s and Fitch. These municipalities are not quite as financially strong as those with the highest rating. Bonds with decreased financial strength are rated Aa2 by Moody’s, and AA by Standard & Poor’s and Fitch. The lowest high-grade bonds are rated Aa3 by Moody’s, and AA- by Standard & Poor’s and Fitch.
Upper Medium-Grade Bond Ratings
Upper medium-grade tax free bonds are still considered creditworthy, but the issuing municipalities are financially weaker than municipalities issuing high-grade bonds. The interest rate increases along with the bond’s possibility of default. The highest grade of upper medium bonds are rated A1, A2 and A3 by Moody’s, and A+, A and A- by Standard & Poor's and Fitch.
Medium-Grade Bond Ratings
Municipalities that issue bonds rated as medium-grade should be able to meet their obligations provided economic conditions remain unchanged. Bonds rated Baa1 by Moody’s, and BBB+ by Standard & Poor’s and Fitch, have the highest ratings in this category. Below that among medium-grade municipal bonds are those rated Baa2 and Baa3 by Moody’s, and BBB and BBB- by Standard & Poor’s and Fitch.
Low Medium-Grade Bond Ratings
Low medium-grade bonds carry below-average credit ratings. The issuing municipalities may have trouble paying their obligations timely. The bonds carry higher interest rates than higher grade bonds. Moody’s rates these bonds as Ba1, Ba2 and Ba3, while Standard & Poor’s and Fitch rates them as BB+, BB and BB-.
Low-Grade Bond Ratings
Municipalities with low-grade rated bonds are vulnerable to defaulting on their interest and principal repayment obligations. Bonds rated as Caa by Moody’s, and CCC by Standard & Poor’s and Fitch, are vulnerable to paying late or missing payments. Bonds rated as Ca by Moody’s, and CC by Standard & Poor’s and Fitch, are highly vulnerable to paying late or missing payments. Bonds rated as C by Standard & Poor’s and Fitch are vulnerable to not making their payments altogether. Default may be forthcoming.
Default Bond Ratings
Bonds rated as C by Moody’s, and D by Standard & Poor’s and Fitch, have failed to pay their obligations. The municipalities may be on the verge of bankruptcy or may have already filed. At this point, bondholders may be lucky to receive any amount of their original principal investment back.
Based in St. Petersburg, Fla., Karen Rogers covers the financial markets for several online publications. She received a bachelor's degree in business administration from the University of South Florida.