Municipal bonds have a strong historical record of timely interest payments and timely repayment of principal. A municipal bond default is a rare event. Even in the depths of the most recent recession, no major US city, state, town, or school district with an investment-grade bond rating has defaulted on their general obligation (GO) debt; the one exception is Jefferson County in Alabama. (To reiterate, a default occurs when a bond issuer misses an interest payment or does not pay the principal exactly on time.) As a broad category, municipal bonds have much lower default rates than corporate bonds.
Next to US treasury bonds and instruments guaranteed by the US government (this includes CDs and bank obligations guaranteed by the federal government), it could be argued that municipal bonds are the next safest category of investment. However, there are 80,000 issuers of municipal bonds of various types. It must be noted that what may be true for the municipal bond category as a whole may not be true for thousands of individual issuers.
To really understand what you are buying, you should know that certain categories of municipal bonds are safer than others. From the previous chapter, you will remember the distinction between general obligation bonds and revenue bonds. The type of bond and the type of issuer matters a lot. Bond ratings are one way to measure risk, but understanding the default characteristics of various types of bonds at a high level can help you avoid unnecessary risk.
Historical Defaults and Recovery Rates
History should not be your only guide as the future can present unique events. That said, the last time a US state defaulted on a municipal bond obligation was during the great depression. During the Depression, Arkansas was the only state that defaulted on its general obligation bonds. Prior to the Great Depression, the only other state defaults occurred during the Civil War. Before we cover default rates further in the next chapter, you need to understand the important concept of recovery rates.
The recovery rate is what bondholders end up collecting after a default. This is similar in concept to a foreclosure. If a bank forecloses on a homeowner, the bank does not lose everything it initially lent. The bank gets to sell the house to recover as much as they can. Once a bond issuer defaults by missing an interest payment or principal payment, the recovery rate is how much the bondholders ultimately get back on what they were owed. Municipal bond defaults have very high recovery rates; on general obligation defaults from rated issuers, meaning municipal bonds that have ratings assigned to them, the recovery rate is close to 100 cents on the dollar. For instance, even with the well- known and large municipal bond default of Orange County, California, the recovery rate was 100 cents on the dollar. Bondholders that held on to maturity did not lose any money. Orange County, who was in technical default related to tender option bonds, did not miss a single interest payment or principal payment.
Understanding recovery rates is your margin of safety in the event a bond defaults. On rated general obligation bonds, the recovery rate on bonds is almost 100%. The reason is that if a municipal issuer defaults on general obligation debt, the issuer is obligated to use every bit of taxation power at their disposal to satisfy bondholders. The full faith and credit of the issuer is the guarantee that is backing the bonds. For instance, a local issuer may have to increase property taxes dramatically: a state may have to increase income taxes or corporate taxes, a county may have to sell off a major park, or a small town might have to sell buildings. Whatever means can be used to get the bondholders their money has to be exercised. In many states such as California, general obligation debt of the state is mandated by its state constitution to be paid back before fulfilling many of its other obligations.
It is, however, different with revenue bonds. With revenue bonds, there is no general guarantee. Your claim as a bondholder is limited to the revenue stream and assets that were pledged by the bond issuer. For instance, if the bonds were for building or improving toll roads, the bonds are backed by the revenues from the toll road. The toll revenues are your only recourse. This means that the issuer operating the toll road could increase the toll rate substantially, but that may result in lower revenues since people may switch to free roads. Big picture: You should know that recovery rates on revenue bond defaults are lower than the recovery rates on general obligation bonds.