As someone interested in buying municipal bonds, safety is and should be your paramount concern. It will help you to know the history of defaults over the past 40 years. The research that we are going to reference is a recent report from Moody's analyzing defaults from 1970-2011. In this report, Moody's looked at every single bond default on municipal bonds rated by Moody's since 1970. Out of thousands of bond issues rated by Moody's over this time period, there have been a total of 71 bond defaults over the past 41 years.
Of the 71 defaults, 5 of the defaults were on general obligation debt. The vast majority of the bond defaults occured in the healthcare and housing sectors. When issuers such as hospitals and housing projects default on bonds, the amount recovered also tends to be much lower than for general obligation bonds. This gives us an easy rule to work with: Avoid hospital/healthcare-related bonds and avoid multi-family housing projects. There are over 80,000 issuers; eliminating a few problem categories of issuers from your investing consideration will not limit your choice in any material way.
|Default Counts By Sale Purpose, 1970-2011|
|Purpose||Number of Defaults||Percentage|
|Hospitals & Health Service Providers||23||32.4%|
|Water & Sewer||1||1.4%|
|Non General Obligation||66||93.0%|
|Source: Moody's (As of 3/7/12)|
Also, be advised that the above data applies to bond issues rated by Moody's. Many bond issues are not rated at all. If it is not rated, do not buy it unless you have significant expertise on how to value the bonds.
It is difficult to paint revenue bonds with a broad brush in terms of risk. But compared to general obligation municipal bonds, the vast majority of municipal defaults result from revenue bonds. The following is chart from Moody's on the 10-year cumulative default rates of all municipal bonds. Cumulative default rate means that the default rate from a previous year is added to the following year's defaults (when you look at year 10 it is the sum of all defaults from the previous 10 years.) The chart is compiled by rating category.
Average Cumulative Default Rate of Moody's-rated Municipal Bonds - 1970-2009:
You will notice that the 10-year cumulative default rate from this period on Aaa-rated municipal bonds is 0%. On Aa and A rated municipal bonds, the 10-year cumulative default rate is .03% for each category. This means that on average, 3 out of 10,000 municipal bond issues rated double A or single A by Moody's defaulted over a 10-year span. .03% is 3 out of 10,000. To get a sense of the track record of municipal bonds, compare the cumulative default rates to corporate bonds from the same time period.
Average Cumulative Default Rates on Moody's-rated Corporate Bonds 1970-2009
Overall, municipal bonds have a safety record second only to the US government. It is helpful to know the big picture in terms of past default rates. In the future, the default risk might be higher than in years past. As you consider buying individual municipal bonds for your portfolio, you should try to understand the individual characteristics of the bonds that you are buying. One way to do this is to read the official statement put out by the bond issuer. It will tell you a great deal about the economic circumstances of the borrower. If it is a general obligation bond, understanding things like median income, median wealth, home values, population growth, and types of employers can give you a measure of an area's economic strength.
Another way to pursue safety is to stick with state general obligation bonds and general obligation bonds issued by smaller wealthy communities. Here's why: A state has virtually unlimited taxation power over its residents and businesses; this gives a state issuer many options and avenues of recourse in satisfying bondholders in the event of hardship. With wealthy communities, the primary method of taxation is property taxes. Wealthy communities, by definition, have high median incomes and high home prices. The higher the aggregate value of the property, the more there is for a local government such as a township or village to tax.
Getting comfortable with the track record of municipal bonds is necessary for you in evaluating various offerings. You should compare the yield you are being offered on a bond to US treasury bonds with a similar maturity date. Since US treasury bonds are deemed to carry no credit risk, you need to know how much more yield you are getting for buying the municipal bond? Are you being compensating properly for taking on additional risk? Understanding the default risk of municipal bonds will help you with this.