Municipal Bond Defaults: Don’t Believe the Hype

There are 2 big differences between Corporate and Municipal Bond Credit Ratings that investors interested in municipal bond defaults should be aware of .

  1. The supply of high rated municipal bonds is far greater than that of high rated corporate debt.
  2. The average municipal bond default rate is extremely  low compared to corporate bonds, even when comparing bonds with similar ratings.

The highest credit rating is AAA. While 16 of the 50 States have triple AAA credit ratings, less than 5 US corporations have AAA rated debt.  Over 90% of municipal debt (rated by Fitch), is rated in the A range, also known as high-investment grade. The majority of corporate debt is in the “B” range which includes low investment grade and junk bonds.

 

What is the probability of a municipal bond default?

Moody’s has compiled information which includes data from 1970 – 2011. Moody’s has said that it expects for municipal bond defaults to modestly rise, but it gives a basic framework for looking at municipal bonds.

Municipal Bond Defaults Compared To Corporate Bonds With The Same Rating

Rating Municipal Bond Corporates
AAA 0.0% 0.48%
AA 0.01% 0.86%
A 0.04% 2.22%
All Ratings 0.13% 11.17%
  • There have been no municipal bond defaults on bonds rated AAA.
  • Less than 1 in 2000 A rated municipal bonds default
  • Single A rated municipal bonds have less than one-tenth the defaults of AAA Rated corporate bonds

Historically, municipal bonds are between 50 and 100 times less likely to default than corporate debt with the same rating.

While we do not expect municipal bond defaults to climb to a much larger percentage of the overall market, there are some things that investors should be aware of:

  • Recent municipal bond defaults have increased – In 2010 and 2011, the rate of defaults for municipal bonds has doubled. When looking at the actual numbers however, we are still talking about a very low number.  There was an average of 5.5 municipal bond defaults per year during this time vs. an average of 2.7 defaults per year for the previous 39 years.
  • Ratings can change over time. In any given year, between 5 and 10% of municipal bonds can have their ratings changed or withdrawn. The largest portion of rating changes is one grade down. For example, a bond rated AAA becoming AA.
  • The rating agencies have been trying to correct the difference between municipal and corporate ratings. In 2010, Moody’s and Fitch both changed the way they rated municipal bonds, resulting in a large number of upgrades. More recently, S&P has announced that it may be making changes as well.
  • Aging baby boomers will be hurting municipal finances. Municipalities will be taking a double hit from America’s aging population. Less workers means lower tax revenues. More retirees means a bigger portion of budgets will be going to cover underfunded pension liabilities and medical costs.

 

It is also worth noting that not all types of municipal bonds have the same default rates.

  • General Obligation bonds have had an even lower default rate than revenue backed bonds.  According to Moody’s only 5 defaults have occurred in General Obligation bonds in the last 41 years.
  • Revenue bonds related to housing and healthcare projects have the highest default rates.  Close to 75% of defaults over that same time period were from these two sectors.

This lesson is part of our Free Guide to the Basics of Investing in Municipal Bonds. Continue to the next lesson here.

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