"There's not a doubt in my mind that you will see a spate of municipal-bond defaults." Meredith Whitney, Analyst, December 2010 municipal bond call that went awry.
State budgets are a mess. Tax receipts are down due to elevated unemployment. Business taxes have slumped due to reduced sales or outright closures. Unfunded pension liabilities keep growing while interest rates are stuck at 0%.
Surely the pain will trickle into the municipal bond market, which could lead to widespread defaults. Borrowers could face capital losses and massive haircuts in a historically safe asset class.
The disaster scenario makes for a great headline, but history is not on the side of municipal carnage (we've been here before, see Meredith Whitney's infamous call in 2010, which unfortunately derailed her career).
We separate fact from fiction for the municipal bond investor.
What is the Likelihood that my Municipal Bonds Default?
According to Moody's, from 1970 through the end of 2015, out of the thousands of muni bonds issued across the country, there were just 99 defaults. That translates into an annual default rate of 0.09% for all-rated municipal bonds. Investment grade "AAA" and "AA" rated munis experienced zero defaults.
For comparison purposes, all-rated corporate bonds had a historical default rate of 10.13% during the same period.
The short answer is, not likely. That doesn't mean you should blindly purchase any type of municipal bond.
What Are the Characteristics of Bonds that Do Default?
According to a study by the Brookings Institution, bonds that haven’t been rated by a credit rating agency (Moody's, Fitch, or S&P), uninsured bonds, or bonds that are not Government Obligation (GO) bonds are much more likely to default.
Per our "Municipal Magic" post, investors should use common sense when buying municipal bonds. Avoid small, obscure issues. Beware of bonds that haven't been rated by Moody's or S&P (we prefer bonds that have been rated within the last three years). Be skeptical of outsized yield. If it seems too good to be true, it is.
At the sector level, real estate backed deals (tied to future property tax receipts, land development projects, multi-family housing, etc.) are the biggest source of defaults. This makes sense as many real estate projects require leverage; and property values can be volatile, especially during deep recessions.
Would the Federal Government let a State Default?
Technically, no. State bankruptcy is unconstitutional as it violates Article 1 Section 10 of the US Constitution, which prohibits States from "impairing the obligations of contracts."
Therefore, Congress would have to vote to amend the Federal Bankruptcy Code, allowing States to default on their financial obligations. Keep in mind, this only applies to U.S. states. Other municipalities, such as cities, counties, revenue or project backed bonds can very much go bankrupt.
Is the Municipal Bond Market Showing Signs of Stress?
Since the dislocation in spring of 2020, the municipal bond market has normalized. The Fed began accepting municipal bonds as collateral to provide liquidity to banks. It also began directly purchasing municipal bonds to help states deal with revenue shortfalls and a frozen debt market.
The above is a snapshot of municipal bond yield to maturities by credit rating. The municipal bond market is huge. The first signs of trouble would show up in the form of elevated yields and lower prices. The current muni market is not showing signs of stress.
The Fed's pledge to keep interest rates low for the foreseeable future also helps municipal issuers. They can call or refinance higher cost debt and reissue new debt at the lower market rate. We are seeing this in our municipal portfolios, receiving a notice of a called security almost daily. Lower interest expense is helpful to state budgets.
If you're anticipating mass defaults in your municipal bond portfolio, history is not on your side. Stick to rated bonds (preferably investment grade), avoid small, obscure projects, and be wary of outsized yield.
Let us know if you would like to learn more about our approach to municipal bond investing.