CFA Practice Question
Why does a prerefunded municipal bond not expose investors to credit risk? Choose the best answer.
A. Once a municipal bond is prerefunded, the issue is collateralized by a portfolio of U.S. Treasury obligations, which possess no credit risk.
B. Once a bond is prerefunded, bondholders are paid the entirety of their principal and the debt issue is retired.
C. Only municipalities given express authority by the United States Government may prerefund their bonds, and the U.S. government will therefore back the issue.
Explanation: Prerefunded municipal bonds do not expose investors to credit risk, and this is an important consideration in the analysis of any prerefunded municipal bond. Once a municipality decides to prerefund an outstanding debt obligation, the municipality collateralizes the bond issue with a portfolio of U.S. Treasury Securities, and the cash flows of this portfolio are used to pay the principal and interest of the prerefunded municipal bonds. U.S. Treasury securities possess no credit risk, therefore prerefunded bonds possess no credit risk because the portfolio of bonds used to collateralize them represent a direct obligation of the United States Treasury.
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