Munis have earned a well-deserved reputation as a safer segment of the fixed income market over decades of lower default rates and higher recovery rates than corporate debt markets. However, as a market with over 50,000 issuers and approximately 1,000,000 outstanding issuances, navigating credit risk in the Muni market can be a challenge for investors looking to branch out from laddered, investment-grade mutual funds or ETFs. In this blog post, we will explore several noteworthy municipal defaults, the concept of credit risk specific to municipal bonds, and the key factors that influence it.
Below is an overview of 10-year cumulative default rates (CDRs) for Moody’s rated securities:
*Recovery Rate since 1970 for Moody’s-rate Municipalities, since 1987 for Senior Unsecured Corporate Bonds.
Given the lower default rates associated with rated municipal bonds, investors might assume that their tax-adjusted yields would be lower, reflecting the higher quality of the asset class. This is rarely the case. In fact, the S&P Investment Grade Muni index has a yield to worst of 3.73% as of May 25, 2023, with a tax-equivalent yield of approximately 6.30% (for high income tax bracket investors). This compares to the S&P Investment Grade Corporate Bond index which yields 5.42%, or .88% below the tax-adjusted Muni benchmark. The additional yield offered by Muni bonds can be attributed to a liquidity premium as a result of the unique market dynamics exhibited in the municipal bond market. See our post on ‘Retail Domination and the Liquidity Premium’ for further details on these unique characteristics.
Historical Municipal Bond Defaults
While defaults in Munis are rare, they do occur but are typically idiosyncratic and can be years in the making. Below are just a few examples of defaults that have occurred in past decades. Notice that defaults can be unique to specific issuers but tend to aggregate around economic turmoil and are associated with declining demographics, high debt balances and deteriorating consumer trends.
The Great Financial Crisis
During the Great Financial Crisis, which occurred between 2007 and 2009, municipal credit defaults became a significant concern for local governments across the United States. The crisis had far-reaching effects on the broader economy, leading to a sharp decline in housing prices, widespread job losses, and a contraction in credit markets. These factors, coupled with mounting financial pressures on municipalities, resulted in a wave of credit defaults that threatened the stability of local governments.
Municipalities heavily rely on property taxes and other forms of local revenue to fund essential services, such as schools, infrastructure, and public safety. However, the crisis caused a decline in property values, leading to a reduction in property tax revenues. Simultaneously, the economic downturn resulted in lower consumer spending, leading to decreased sales tax collections. As local governments faced shrinking revenues, they encountered difficulties in meeting their financial obligations, including debt service payments. This, in turn, increased the risk of credit defaults.
As the crisis deepened, several municipalities found themselves on the brink of default. Notable cases included Vallejo, California, which filed for bankruptcy protection in 2008, becoming one of the largest municipal bankruptcies in U.S. history at the time. Other cities, such as Detroit, Michigan, Stockton, California, Jefferson County, Alabama and Harrisburg, Pennsylvania also faced severe financial distress, with mounting pension liabilities and budget deficits. The defaults and credit deterioration had significant consequences for both the affected municipalities and the broader financial markets, as investors became increasingly concerned about the creditworthiness of municipal bonds. These credit issues served as a stark reminder of the interconnectedness between the municipal and financial sectors during times of economic turmoil.
The city of Detroit had approximately $18b general obligation municipal bonds outstanding when it filed for bankruptcy in 2013, making it the largest municipal default in U.S. history at that time. Detroit had been experiencing declining populations and high crime rates for decades, and the economic crisis and rising unemployment experienced during the Great Recession rendered the city unable to service its excessive debt and pension liabilities. In the resulting bankruptcy proceedings, the recovery rates for Detroit’s Muni bonds were as follows: 73% for general obligation unlimited tax bonds, 42% for general obligation limited tax bonds, and 12% for certificates of participation.
Puerto Rico's government debt crisis was years in the marking, culminating with ratings downgrades from investment grade to high yield from 2012-2015 and defaults in 2017. At the time of default, Puerto Rico has approximately $74b debt outstanding and $49b unfunded pension liabilities, around 70% of its GDP. The default stemmed from long-standing economic challenges combining a high debt burden, a shrinking economy, changing demographics, and a lack of access to financial markets. The territory’s municipal debt issuance had been inflated by legislation exempting it from state-taxes nationwide. Bondholders have faced substantial losses, as Puerto Rico's government implements a debt restructuring process in bankruptcy proceedings that is ongoing in 2023.
Colorado Ocean Journey Aquarium
Here in Colorado, the Colorado Ocean Journey aquarium’s default in 2002, after opening in 1999, is an example of the heightened risk in early-stage municipal projects. Partially funded with a revenue-based, non-rated $57m Muni issuance, the Aquarium was initially successful before being hit by the recession, 9/11, and the opening of a second aquarium in Denver. Revenue from ticket sales fell, and the aquarium was unable to meet its $5m debt service payments, filing for bankruptcy in 2002. The aquarium was subsequently purchased at auction for $13.6m by Landry’s Restaurants and has since operated as the Downtown Aquarium.
Factors Influencing Municipal Bond Credit Risk:
a. Economic Condition of the Issuer: The financial health of the municipality plays a significant role in determining credit risk. Factors such as economic growth, tax revenue, unemployment rates, and demographic trends can impact the issuer's ability to meet its financial obligations. As a whole, the Muni market is of significantly higher credit quality than the corporate market; as of 2021 approximately 60% of the rated Muni market have Aa and Aaa ratings, as compared to 5% of rated global corporates (Moody’s).
b. Revenue Sources: Municipalities derive their revenue from various sources, including property taxes, sales taxes, income taxes, and fees. Understanding the stability and reliability of these revenue streams is crucial in assessing credit risk. For example, bonds relying on revenue generation typically have more credit risk and volatility than bonds with a claim on general obligation taxes. Three common municipal bond structures are: General Obligation Bonds (GO), Revenue Bonds (REV), and Certificates of Participation (COP).
c. Sectors: Breaking the Muni market into sectors permits the investor to gain insight into an issuer’s operations, financial profile, and credit risks. Airports, cities, school districts, charter schools, metropolitan districts, senior living facilities, and utilities are a few of the primary sectors in the Colorado Muni market. Issuers within a sector will tend to have similar revenue sources, operating models, and credit profiles. For example, public school districts are a staple of the Muni market that boast low default rates, they generate revenue from state funding and property taxes. Senior living facilities are a riskier sector with one of the highest Muni default rates, typically non-profit entities relying on revenue from the facilities to finance debt obligations.
d. Debt Seniority and Structure: Municipal bonds can have different levels of seniority and structures. General obligation bonds are backed by the issuer's full faith, credit, and taxing power, while revenue bonds rely on specific revenue streams. Certificates of Participaction typically (COPs) have low seniority. Analyzing the debt structure and understanding the order of payment can help assess the credit risk associated with each bond.
e. Bond Insurance and Guarantees: Some municipal bonds are insured or guaranteed by third-party entities, such as bond insurers or state agencies. For example, the Intercept and Moral Obligation program in Colorado improves the credit profile of 103 charter schools around the state. Insurance and guarantees can enhance creditworthiness and reduce credit risk. However, it is essential to evaluate the financial strength and creditworthiness of the insurer or guarantor as well.
Assessing Municipal Bond Credit Risk:
a. Credit Ratings: Credit rating agencies assign ratings to municipal bonds based on their assessment of credit risk. These ratings provide investors with an indication of the issuer's ability to meet its debt obligations. Ratings range from AAA (highest) to D (default). There are various reasons an issuer won’t apply for a rating, so non-rated bonds merit closer examination as they have historically defaulted at higher rates than the rated municipal bond universe. However, it is important to note that credit ratings are opinions and should be used as a starting point for analysis rather than the sole determinant of credit risk.
b. Fundamental Analysis: Conducting in-depth fundamental analysis of the issuer is vital in evaluating credit risk. This analysis involves reviewing financial statements, legislation, demographics, competitive landscape, and bond structure to assess the issuer's financial health, revenue sources, and debt management practices. A hands-on approach to credit analysis, focusing on in-state municipalities and site-visits, can also provide a competitive advantage when analyzing municipal issuers.
The Municipal bond market is of high credit quality, which is particularly evident in the investment grade, rated universe. However, non-rated Munis have historically defaulted at higher rates than rated Munis, and although average recovery rates are higher than corporates there is wide variability depending on the circumstances. By considering factors such as the economic condition of the issuer, revenue sources, debt structure, and bond insurance, investors can make informed decisions and effectively manage their credit risk exposure. Conducting thorough analysis, monitoring credit ratings, and seeking professional advice are recommended steps for every investor to navigate the Muni market.
Senior-Living Debt Defaults Far Outpace the Rest of Government Debt Market; Bloomberg, 2023
Charter School Intercept and Moral Obligation; Colorado Department of Treasury, 2023
US municipal bond defaults and recoveries, 1970-2021; Moody’s, 2022
The City of Detroit Bankruptcy; MunicipalBonds.com, 2019
Debt is Closing Denver’s 3-Year-Old Aquarium; New York Times, 2002
Municipal Market by the Numbers; MSRB, 2022
Official Statement, Colorado’s Ocean Journey, Inc Project Series 1997; EMMA, 1997
S&P Dow Jones Indices
This content has been prepared for informational purposes only and should not be considered as investment, tax, or legal advice. We recommend all investors to consult with a financial and/or tax advisor regarding their individual circumstances before taking investment decisions.
Investing in bonds exposes the investor to the risk of loss of principal. Lower and non-rated securities are more volatile and less liquid than investment grade bonds.
Please visit our website for a complete list of disclosures and risks: www.maustininvestments.com.