S&P released its US Municipal Bond Default Analysis, updated for 2011, providing a good opportunity to review the historical default risk on municipal bonds and to put this risk into the proper perspective. The easiest way to do this initially is to compare this risk with the municipal bond’s taxable equivalent brother, the corporate bond.
According to a Moody’s Special Comment, the 2008 financial crisis had a “crippling effect on corporate bond defaults”. Lehman remains the poster boy of the year, and combined with Washington Mutual, Tribune Company, and GMAC, makes for a distinguishing list of who’s who for bankrupt companies. By the end of 2008, over 101 Moody’s rated corporate issuers defaulted for a total of $226.2 billion. In 2008, the default rate jumps from a paltry .49% in 2007 to 2.45%. Even more despairing is that the report shows an average recovery rate of 33.8% in 2008 versus 53.3% 2007. Let’s move ahead one year, it got even worse for corporate debt; the default rate was 5.68% in 2009. This compares with a great depression record peak of 8.42% in 1933.
You will remember some of the “non-municipal experts” were calling for a credit crisis in the municipal market for 2011. Numerous defaults and a lot of credit downgrades would highlight the deteriorating quality of municipal finance during 2011. Let’s review default rates and changes in credit quality during the time frame leading up to and including the economic crisis (2000-2011) and see if it is also “crippling”.
DEFAULT RATE: MUNICIPAL VERSUS CORPORATE BONDS COMPARISON
Annual municipal defaults, not counting housing issuers, have ranged from a low of .00% in 2007 to a high of .05% in 2001. On average, the rate has been .02% with 2011 being above this average at .03%. Actual default rate for municipal bonds (including housing bonds) over the time period of 1986-2011 has been .30%. Corporate bonds, on the other hand, hit a low of .49% in 2007 and peaked in 2009 at 5.68%, averaging 2.39% over the time period.
Both municipal and corporate bonds experienced an increase in default rates during the economic crisis. The extent of this increase is quite different. Municipal bonds, non housing issuers, “max out” in 2008/2011 at .03%. Corporate default rate “max out” in 2009 at 5.68%. In other words, for every 10,000 issuers in the municipal market, roughly 3 defaulted. This compares with roughly 568 corporate issuers.
There are some faults with this type of default analysis, which must be disclosed. They are as follows:
- The riskiest issuers do not usually apply for a credit rating. Therefore, the default rates are usually understated.
- Not all issuers are rated by Moody’s and S&P. The issuer may have a strong credit rating, but do not want to pay for two credit ratings and, therefore, are rated by only one agency. If you look at each agency’s separate default studies, the numbers are slightly different.
- The annual default rates calculated in these analyses have “time bias” that makes them lower. As more municipalities issue bonds and have them rated, the population of outstanding debt grows. This creates a larger base to calculate default rates from. More specifically, the same number of defaults could have occurred in 2000 as occurred in 2010, but with more bonds being rated by S&P in 2010, the default rate calculation is lower.
What happens if you own a municipal or corporate bond and it defaults? It is important to know what percent of your investment you may get back after all liabilities are settled. Historical recovery rates, according to a Moody’s study from 1970 to 2009, showed the following:
- Municipal bonds recovered on average $60 relative to a par amount of $100.
- Corporate bonds (senior unsecured) recovered on average $45 relative to a par amount of $100.
CREDIT MIGRATION: MUNI VERSUS CORPORATE BONDS COMPARISON
Another way to view the impact on credit quality over a time series is to see the changes in credit ratings during that period. Moody’s and S&P do annual studies on the migration of credit ratings. This study reflects what percent of the bonds still have the same credit rating one year later. This allows for a comparison of stability in ratings over the time period reviewed.
Below is the chart of transition ratings for municipal and corporate bonds from Moody’s study for 2008-2009:
What does this chart show? For example, the AAA Munis category reveals that 89.83% of bonds rated AAA were still AAA rated at year’s end. Therefore, if there were 100 issuers rated AAA in 2008, only 89ish were still rated AAA in 2009.
The results of this credit migration study shows that municipal bond credit quality was more stable from 20082009 than corporate quality. On average 19% more investment grade corporate bonds were downgraded from 2008-2009 than municipal bonds. These numbers may be a bit skewed as the Federal Government extended a “relief plan” to municipalities in 2008. This definitely helped, but we also had the federal government stepping in with TARP funds to help corporations, too. This is why we need to also look at a transition study for 2009-2010. The numbers should be much more pure and not be “propped-up” from the federal government’s actions.
Once again, municipal bond’s credit quality was more stable. 8.52% more investment grade corporate bonds were downgraded than municipal bonds. There looks to have been a lowering of “lower” (A and BBB rated) credit issuers from 2009 to 2010, but the top tier credit rated issuers (AAA and AA rated), remained stable in credit quality for municipal versus corporate bonds. We believe this was influenced by the loss of the AAA rated monoline insurance firms.
Let’s take the analysis one step further. We believe the above work shows the superior principal protection powers of municipal bonds, but can security selection process improve it? We feel there is a simple investment strategy that can make a principal-first strategy a sleep well at night strategy.
THE SLEEP WELL AT NIGHT STRATEGY
Security selection process can help reduce the chances of an investor losing principal in the municipal market. As the numbers above show, since 2000, there is a rough chance that 3 in 10,000 municipal bonds will default. If an investor purchased only essential service revenue bonds or general obligation bonds, the chances of default reduce considerably. Below is a chart breaking out Moody’s and S&P’s recorded municipal defaults by sector:
As the numbers show, roughly 78-82% of municipal defaults come from the housing and hospital sectors. A majority of the housing defaults are for multifamily projects. Therefore, by restricting your sector choices to not include multifamily housing or hospitals reduces the default rate by three quarters in a given year to roughly 1 in 10,000. That is pretty much the odds of getting hit by lightening during your lifetime, which is 1 in 10,456.
What if we were to restrict the purchase of municipal bonds to investment grade or higher, what would be the odds of default? I will let you do the math, because I think it’s irrelevant and not crippling.