It’s no secret that cities, states and counties across the U.S. are in dire straits. Budget deficits are up, tax revenues are down. What lies ahead for the $2.8 trillion municipal bond market? Are massive widespread defaults of municipal bond issuers in the cards? And how can advisors help their clients to play this ever growing dangerous market?
Before we can ascertain the future of the municipal bond market, knowing its history can add some perspective.
Since 1839, there have been fewer than 10,000 investment grade municipal bond defaults out of over 1 million issues. Almost half of these occurred between 1929 and 1937, in the Great Depression era. A widely cited study by Professor George H. Hempel indicates the majority of defaults that occurred during the Depression era were cured within a few years.
Municipal defaults peaked at $2.85 billion in 1933 and began falling rapidly in 1934 and 1935. By 1939 municipal defaults had declined to approximately $200 million. The Hempel report states that loss of principal and interest from defaults during the Depression period averaged 0.5 percent of state and local debt.
Despite the high recovery percentage, many munis investors were forced to sell and suffered considerable losses during this period. Ron Ryan, CEO of Ryan ALM observes that important differences in fiscal and debt management have evolved since the Depression era. “States and local governments have adopted conservative debt limits, stronger tax enforcement, improved financial reporting and higher oversight of local governments,” says Ryan. Despite fiscal turmoil, he notes that investment grade municipal bond defaults have become a rarity.
Warren Buffett cut his firm’s municipal bond holdings to under $4 billion during the first quarter of this year from almost $5 billion in 2008. In public statements made to the Financial Crisis Inquiry Commission, Buffett voiced concern about the ability of municipalities to pay for the retiree benefits of public workers. He seemed perplexed on how to properly ascertain the credit risk of muni bonds and he made the suggestion that a future federal bailout of strapped cities and states could be next.
Still, there’s a world of difference between budget-strapped local governments and bankruptcy.
According to data from Municipal Market Advisors, there’s $6.3 billion, or less than 0.2 percent of the current muni bond market, presently in default. “Only 14 carried a major credit agency’s bond rating at the time of default, and more than half of the total dollar amount in default ($3.8 billion) is attributable to a single issuer — Jefferson County, Alabama,” notes Rob Williams, director of income planning at the Schwab Center for Financial Research in a recent report.
One of the more unsettling developments within the municipal bond market has been a lack of insurance. This is perhaps one of the clearest signals that things in the muni bond market aren’t the same as before. Not only is the cost of insuring against muni bond defaults escalating but the availability of insurance is scarce. Two years ago, more than 50 percent of municipal bonds were protected with insurance against default. Today, just one active bond insurer remains (Assured Guaranty). The Bond Buyer estimates less than 10 percent of new munibonds issued last year came with bond insurance.