One of the biggest selling points for municipal bonds, and one of their most frequently cited attributes, is their very low default rate. But while default rates in munis are very, very low, they are not zero. Defaults do happen in the municipal market from time to time—one need look no further than recent headlines to see that this is so.
In the summer of 2016, Puerto Rico defaulted on constitutionally guaranteed general obligation bonds, the first such default by an American state or commonwealth since the Great Depression.1 Since then, a federal oversight board has been working with Ricardo Rosello, governor of Puerto Rico, to reach a plan that will allow the island commonwealth to begin what could possibly be the largest ever restructuring of debt in the U.S. municipal bond market of some, if not all, of Puerto Rico's $70 billion debt.2
In 2013, Detroit became the largest U.S. city to ever file for bankruptcy.3 During Detroit's bankruptcy proceedings, financing local pensions took precedence over repaying bondholders, many of whom were required to receive less than they were owed (these bonds were, however, covered by bond insurance).4
Muni bonds, in general, are second only to U.S. Treasuries in terms of perceived safety. Headline-grabbing though the above cases may be, municipal bond defaults remain extremely rare. In the period 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 throughout the 46-year period.5 In fact, investment grade "Aaa" and "Aa" rated munis experienced zero defaults.
Of those 99 defaults, housing accounted for 45.5%, which translates into an annual default rate of 0.089% for all-rated municipal bonds throughout the 46-year period.5 These housing defaults were, in large part, attributable to one of the most popular financing methods a locality might have at its disposal: tax increment financing districts (TIFs). TIFs are largely dependent on rising tax revenues to finance land development projects, for example housing communities.6 As tax revenues rise with higher land values, the additional funds can be used to pay off the bonds that financed the project. The trouble is land values and tax revenues don't always rise as planned. TIFs were put under tremendous strain in 2007 and 2008 as the housing bubble popped and land values fell.
Hospitals and healthcare were the second-most common source of default in muni bonds from 1970 through 2015, accounting for 23.2% of all defaults, for an annual default rate for all ratings of municipal bonds of 0.088% throughout the 46-year period.5
General Obligation (GO) bonds only experienced nine defaults throughout the same 46-year period, for a very low annual default rate of 0.003%.5 Within that context, it's worth taking a closer look at what, if anything, could contribute to elevated defaults in GO bonds in the coming years. One of the most likely candidates that could potentially cause trouble for GO munis going forward is pension reform.
Defaults by Sector 1970-2015
Source: Moody's Investors Service.
Although many states have underfunded pension systems, thanks in part to tighter budgets and modest annual returns on investments,7 perhaps no state is more emblematic of the coming reckoning in pensions and municipal bonds than Illinois. This state has one of the most chronically underfunded pension systems in the country. As of 2015 Illinois' state pension debt had reached a record $111 billion, growing by $20 million per day as the state budget remained at an impasse.8 In a further illustration of the trend, Chicago, the state's largest city, recently had its credit rating downgraded to a notch above speculative status by Moody's, thanks to its ongoing underfunded pension system.9 As of April 10, 2017, the state's budgetary problems remained unresolved.
Illinois and Chicago, while extreme examples, are hardly exceptions. Kentucky and New Jersey's pension systems remain severely underfunded as well.10 Much like Chicago, Dallas's credit rating was downgraded in early 2017 by S&P over fears that its pension system continues to be underfunded. There is a distinct possibility that lawmakers may pass bills preventing states from "kicking the can" when it comes to unsustainable pension obligations, and this could potentially put stress on municipal bonds, including GO bonds.
All-in-all, although muni bond defaults remain very low, it's worth acquainting oneself with the contributing factors that can lead to a default, as well as the potential changes in today's landscape that may affect issuers' creditworthiness down the road.
5Moody's Investor Service, US Municipal Bond Defaults and Recoveries, 1970-2015 (May 31st, 2016 – Page 16).
The Moody's rating scale is as follows, from excellent (high grade) to poor (including default): Aaa to C, with intermediate ratings offered at each level between Aa and Caa. Anything lower than a Baa rating is considered a non-investment-grade or high-yield bond.
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