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Municipal Bonds Not as Safe as Thought? Hardly
A couple weeks back, the Federal Reserve Bank of New York ran a blog post on the default history of the municipal market. A few news outlets made it seem like the blog’s content was actually groundbreaking news. In reality, anyone who has paid attention to the history of the municipal bond market knows that:
  • Unrated bonds have defaulted in much greater numbers than rated bonds and the popular studies by Moody’s and others typically don’t account for unrated bond defaults.
  • Defaults generally tend to occur in riskier revenue bond sectors like industrial development, housing, nursing homes and health care.
Those caveats aside, there were some interesting nuggets in the piece.
 
The post notes that Moody’s reported 71 municipal bond defaults from 1970 to 2011. For the same time period, there were 2,521 defaults when unrated municipal bonds are included. This demonstrates that simply having a rating tells you a lot about the likelihood that a municipal bond will repay all principal and interest. It’s likely also true that a sizeable fraction of the unrated municipal bonds would have received fairly low ratings if they had been rated. Many issuers of unrated bonds likely knew this and therefore simply chose not to pay to have their bonds rated.
 
The report also reinforced the sectors of the municipal bond market that tend to be the most likely to default. A graphic in the post makes the point clear. Historically, most defaults are associated with non-essential service revenue bonds. In particular, the industrial development, housing, nursing home and health care sectors stand out. These sectors accounted for about 70 percent of all defaults, which is certainly consistent with the oft-referenced Moody’s study on rated bonds.
 
I do want to be clear though. I’m not saying that municipal bonds are as safe as Treasury bonds or other high-quality federal debt. They clearly aren’t, and therefore diversification across issuers is important. Further, many municipalities are seemingly facing more financial difficulty today than they have at virtually any other point.
 
What I am saying is that it was already well known to the marketplace that only counting defaults on rated bonds understates the true number of defaults and that most defaults occurred in non-essential service revenue sectors.
 
Random Links and Commentary of the Week
 
I really enjoyed this piece on Jack Bogle in the New York Times. Jack’s energy is absolutely amazing and his story is remarkable. As an interesting side note, I once tried to take a picture of the ship shown in the piece at Vanguard’s headquarters, and the security guard did not like it. So if you find yourself at Vanguard’s headquarters, watch out for the security guard.
 
Jared Kizer is the director of investment strategy for BAM Advisor Services. See our disclosures page for more information.

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