How Safe is the Muni Bond Market?

In a new post at the New York Federal Reserve’s blog site, three bank officials took a look at the $3.7 trillion US municipal bond market. After noting that about 75% of US municipal bonds are held by individuals or mutual funds, the authors sought to discover whether the low default rates usually cited for the bonds were in fact accurate.

According to their research, Moody’s reported just 71 defaults on rated bonds between 1970 and 2011. Standard & Poor’s reported an even skimpier 47 defaults on S&P-rated bonds. While these numbers may be accurate, the number of unrated bonds is much higher, and the default rates are much higher as well. The research yielded 2,527 municipal bond defaults from 1958 through 2011.

The researchers suggest that the difference is due to a couple of factors. First, not all bonds are rated, with the result that only the gold-plated variety ever go through the rating process. Second, different kinds of bonds perform differently. General obligation bonds, backed by the municipality’s taxing authority, are more likely to get an investment-grade rating than are revenue bonds backed by a revenue stream from an enterprise like a hospital or an airport.

A variety of revenue bonds known as ‘industrial development bonds’, which back things like power plants and pollution control facilities, make up the majority of revenue bonds and are particularly risky because they have a short track record.

The conclusion: muni bond defaults are far more common than believed and investors should be cautious. The authors also note that since bond insurers lost their ‘AAA’ ratings following the financial crisis of 2008 they no longer play much of a role in the muni bond market.

The original post is available here.

Paul Ausick