How to avoid municipal bonds that default

man worried looking at computer
  • Several high-profile bankruptcies have thrust municipal financing in the spotlight.
  • Municipalities raise money by issuing general obligation bonds and revenue bonds.
  • Unrated bonds are not rated because they're not considered investment grade.

Since the financial crisis, analysts have speculated on the degree to which municipalities and their ability to pay creditors would be hit. Unemployment, the foreclosure crisis and sprawling pension obligations have intensified the struggle in some areas -- for instance, San Bernardino, Calif., and Stockton, Calif.

While default rates remain low, several high-profile bankruptcies have recently thrust municipal financing back into the spotlight. Though experts insist that the municipal bond market is generally safe, a recent report from researchers at the Federal Reserve Bank of New York may undermine those assertions in the minds of investors.

Defaults reported by credit rating agencies such as Moody's don't tell the whole story, as they only include rated bonds, according to the Fed researchers in their blog post titled, "The untold story of municipal bond defaults." Including unrated bonds in the total number of defaults exponentially increases the number of defaulted municipal bonds.

Still a pretty low number

Consider the time period between 1970 and 2011: Over the 41-year time frame, Moody's reported 71 defaults, while the economists at the Federal Reserve Bank of New York found 2,521 defaults. Meanwhile, Standard & Poor's 500 index reported only 47 defaults since 1986, while Fed data show 2,366 since then.

But there is a reason unrated bonds have no rating. "They can't get an investment-grade rating," says Robert Doty, president of AGFS, a Sacramento, Calif.-based consulting firm to municipal securities issuers, and author of the "Bloomberg Visual Guide to Municipal Bonds."

Unrated bonds comprise a small portion of the $3.7 trillion municipal bond market, but they account for most of the defaults, according to Doty.

"Somewhere around 20 percent of the bonds are responsible for 80 percent of the defaults. And 80 percent of bonds are responsible for 20 percent of defaults," he says.

Most small investors concerned with credit risk should stick to rated bonds and, more specifically, general obligation bonds or traditional revenue bonds. In municipal bankruptcies, the types of securities at risk of default are "securities payable from community general funds. And that is not a general obligation bond," Doty says.

"If you look at the nature of the credit behind Jefferson County, Stockton, San Bernardino, Orange County, New York City -- all the spectacular defaults have been general fund obligations," he says.

Bonds payable from the general fund are sometimes called special assessment bonds. Interest and repayment come from taxes on the neighborhoods benefiting from the projects the bonds fund. For instance, in 2011, Jefferson County, Ala., declared bankruptcy as a result of a sewer-system project run terribly amok.


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Different types of muni bonds

There are many types of municipal bonds, but the broadest categories are general obligation bonds and revenue bonds. General obligation, or GO, bonds are backed by the credit of that state or local government and their ability to tax. They are not guaranteed. In some instances issuers can still default if they go into bankruptcy. But most issuers don't want to go into bankruptcy because it will adversely affect their credit rating.

"The tax-free financing is a benefit. The problem is the bond market has a long memory. If you do jeopardize your financing, the market doesn't forget. So the cost of financing going forward is very elevated for a long, long period of time," says William Larkin, fixed-income portfolio manager at Cabot Money Management in Salem, Mass.

Revenue bonds are typically issued to fund specific projects and will be repaid by special taxes or by the revenue generated by the project -- for instance, airports collect fees from airlines, and toll roads are paid by commuters who use them. Historically, the safest types of revenue bonds are traditional water and sewer revenue bonds.


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