From the October 2012 issue of Research Magazine • Subscribe!

Don't Discount Muni Risks

Municipal bonds have lower default rates and carry lower risk because credit raters say so—how many times have we heard that?

A new study by the Federal Reserve Bank of New York debunks this theory. The study found that rating agencies are only counting defaults for the municipal bonds they rate, and as a result, they’re providing a distorted picture of actual default rates in the munibond market. 

Moody’s Investors Service (Moody’s) and Standard and Poor’s (S&P) provide annual default statistics for the municipal bonds that they rate. S&P reports that its rated municipal bonds defaulted only 47 times from 1986 to 2011. Similarly, Moody’s indicates that its rated municipal bonds defaulted only 71 times from 1970 to 2011.

Instead of agreeing with Moody’s 71 listed defaults from 1970-2011, the Fed’s database shows 2,521 defaults during this same period. Similarly, the Fed’s data shows 2,366 defaults from 1986-2011 versus S&P’s 47 defaults during this same period. In total, the Fed discovered 2,527 munibond defaults from the period beginning in the late 1950s through 2011.

Put another way, credit rating agencies are understating historical default rates in the municipal bond market because they exclude unrated bonds, which paints a false picture of credit risk. 

Savvy investors like Warren Buffett realize this and recent moves show waning confidence in the municipal bond market. In August, Buffett’s holding company, Berkshire Hathaway, ended credit default swaps insuring $8.25 billion in muni bond debt. 

The highest munibond defaults are concentrated in community development projects, multi-family housing, and the industrial development sector. 

Financial advisors should check their clients’ exposure to individual muni bonds to avoid exposure to troubled issues. 

Finally, diversifying credit risk via muni bond ETFs is a good idea, but an aggressive approach toward protecting capital may mean avoiding this troubled category altogether.

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