Credit Concerns Within the Municipal Market
2010 - September - Category: Fixed Income
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There continues to be intense media focus on budget and pension obligation problems within the municipal market. However, it is important to remember that default risk has been incredibly small in the municipal market. The following provides our take on the municipal bond market.
We believe that while there is more cause for concern now in the municipal bond market, it is also important to remember that default risk has historically been small (especially compared to the corporate bond market), particularly for highly rated issuers. Further, bondholders have typically recovered a substantial fraction of their original investment when municipal bonds have defaulted (again in contrast to the corporate bond market).
Let’s review the historical experience of default and recovery rates within the municipal market, what states and municipalities are doing now and what impact these observations should have on the positioning of your municipal bond portfolio.
Historical Defaults and Recovery Rates
In the most recent annual study by Moody’s on municipal defaults, it found:1
- 54 municipal bonds rated by Moody’s defaulted over the period of 1970–2009. This contrasts with 261 Moody’s-rated corporate defaults in the year of 2009 alone.
- Of the 54 recorded defaults, 78 percent occurred in the healthcare and housing project finance sectors (which we completely avoid).
- Investment-grade municipal bonds had a cumulative five-year default rate of 0.03 percent, compared to 0.97 percent for investment grade corporate bonds. This means that investment-grade corporate bonds were more than 30 times more likely to default than investment-grade municipal bonds.
- Municipal bonds with ratings within our buying parameters had a cumulative five-year default rate of just 0.006 percent.
- The average recovery rate for defaulted municipal bonds is 60 percent, compared to 38 percent on corporate bonds. The recovery rate is the fraction of par recovered after the bonds defaulted. A higher recovery rate is better for bondholders. For example, a recovery rate of 100 percent effectively means investors experienced very little (or even no) loss even though the bond defaulted.
- Of the five defaults on bonds that fell within our buying parameters:
o Two had recovery rates of 100 percent
o One had a had a recovery rate of 55 percent
o One was a technical default where no principal and interest payments have yet been missed
o One was a default on payments owed to an investment bank, not bondholders
Recent Action by States and Municipalities
States and municipalities generally rely heavily on fixed income markets for financing, so it is important for them to protect the interests of bondholders to maintain access to these markets. We believe recent actions show that states and municipalities are taking steps to protect bondholders. For example:
- Colorado and Minnesota recently reduced the cost-of-living adjustments (COLAs) on public pension payments.2
- States cut spending by $74 billion since 2008, and more than half raised taxes.3
- Half of states fired workers in the past budget year, and 22 put staff on temporary leave.4
- Arizona sold its House of Representatives and Senate buildings, and California solicited bids for 11 of its office complexes.5
It is also worth noting that debt service is typically a fairly small fraction of state and local budgets. One article put this number at around 3 percent to 5 percent of a typical budget.6
While we believe concerns of municipal market credit risk are generally overblown, two legitimate concerns are:
- Falling tax revenues, as state tax revenues are down almost 12 percent from September 2008 to December 20097
- Underfunded pension obligations
To counter falling tax revenues, states and municipalities have generally reduced expenses and/or increased tax rates. Underfunded pension obligations, however, still need to be addressed. Recent reports have put state-level pension underfunding at anywhere from $1 to $3 trillion depending on how liabilities are valued.8 To put this in context, the size of the state municipal bond market is roughly $1 trillion.9 As noted above, two states have taken steps toward addressing the size of their current pension obligations. We believe more states and municipalities will be following suit, particularly if Colorado and Minnesota’s COLA reductions are upheld by the courts. We will be following these developments.
Impact on Portfolio Composition
We remain comfortable with our buying parameters, which include:
- Purchasing securities rated no lower than A if the security matures within three years or Aa if the maturity is longer than three years, though the majority of our purchases are rated Aa and Aaa
- Avoiding sectors with relatively high historical default rates. Examples include industrial development, hospital revenue, nursing home revenue and multi-family housing
- Avoiding non-rated bonds
- Bypassing the credit rating of the municipal bond insurer (if there is one) or other enhancements and only considering the credit rating of the issuer
- Regularly avoiding securities with yields too good to be true (because they usually are)
In general, here are our thoughts about the municipal market:
- Historically, default rates for the types of bonds we buy have been extremely low, and recovery rates have been relatively high when defaults have occurred. However, that does not mean that municipal bonds are as safe as Treasury bonds.
- States and municipalities generally seem to be securing protection for bondholders, but there is more work to be done, namely figuring out solutions to unfunded pension obligations.
- We expect more stress on the municipal market than previously experienced. We believe this means more downgrade risk and headline risk as opposed to significant increases in default risk.
- We remain comfortable with our buying parameters and believe they significantly limit exposure to default risk within the municipal market.
1 Moody’s Investor Service, U.S. Municipal Bond Defaults and Recoveries, 1970-2009. February 2010.
2 Jeannette Neumann, Pension Cuts Face Test in Colorado, Minnesota. Wall Street Journal, June 12, 2010.
3 William Selway, No Defaults for States as California Favors Bonds Over Workers. Bloomberg, July 14, 2010.
6 Rob Williams, What’s the Credit Risk in Muni Bonds? Schwab.com, June 9, 2010.
8 Robert Novy-Marx and Joshua Rauh, Policy Options for State Pension Systems and Their Impact on Plan Liabilities. Working paper, July 2010.
9 Robert Novy-Marx and Joshua Rauh, The Liabilities and Risks of State-Sponsored Pension Plans. Journal of Economic Perspectives, Fall 2009.
Copyright © 2010, Bayshore Asset Management LLC, with permission. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.