The State of the Municipal Bond Market

Last Updated Jun 11, 2010 10:17 AM EDT

One question I'm getting lately is, "How will the dire financial straits facing some cities and states affect my bond portfolio?" My Buckingham Asset Management colleague Jared Kizer addressed that recently, so I wanted to share his thoughts with you.

As the credit crisis has unfolded, the credit profiles of corporations and governments around the world have deteriorated, and states and municipalities haven't been spared. State and local income tax, sales tax and property tax revenues are down, and liabilities (in the form of pension obligations and other post-employment benefits) are up.

Nationally, one study estimated that state and local pension plans were underfunded by about $4 trillion as of December 2008. (That is, the value of pension plan assets was about $4 trillion less than the value of pension plan liabilities.) And this doesn't include any post-employment benefit plan underfunding.

Several states are also running significant budget deficits. Add on to this that outstanding municipal debt is in the neighborhood of $3 trillion, and there's reason to pay attention to the fiscal status of states and municipalities.

Before getting too carried away with these statistics and recent press on the municipal market, it's worth reiterating a few key aspects of the historical data for municipal bonds:

  • Of the issuers that Moody's rated over the period 1970-2009, only 54 have defaulted. The vast majority of these defaults occurred in the health care and housing project finance sectors.
  • Of these defaults, only three have been on general obligation debt.
  • The historical cumulative five-year default rate for investment-grade municipal debt is 0.03 percent, compared with 0.97 percent for corporate issuers.
  • Recovery rates (that is, what you ultimately get back after a security has defaulted) on municipal bonds have typically been higher than the recovery rates on senior unsecured corporate bonds (roughly 60 percent versus 38 percent).
So as bad as the current state of some states and municipalities may be, municipal bonds have historically been a safe place to invest, especially when compared with corporate bonds.

Also, yields on high-quality taxable municipal bonds are typically lower than the yields on high-quality corporate bonds. This indicates that the market is pricing in lower credit risk for these bonds than for corporate bonds.

It's also worth noting just how difficult it is for a municipality to file for bankruptcy. States aren't even eligible to file for bankruptcy. (Many states also don't allow their municipalities to file bankruptcy, either.) Also, those that do file for bankruptcy may be cut off from the capital markets in the future.

High-quality municipal bonds have experienced lower default rates than high-quality corporate bonds. However, a number of states and municipalities are currently experiencing more fiscal distress than they have historically, indicating that the municipal bond market may be riskier than it has been.

It's also worth noting that Treasury bonds are the only fixed income securities generally considered to be free of default risk. All other types of fixed income securities have some degree of credit risk. To the extent possible, this risk can be mitigated by investing in high-quality sectors of the fixed income market (Treasuries, CDs, agencies and municipal bonds), but credit risk can't be avoided by any means other than investing exclusively in U.S. Treasuries.

Finally, we recommend limiting municipal holdings to bonds rated AAA and AA. (If you're willing to accept the risks of A-rated bonds, the maturity should be limited to three years.) We also recommend avoiding bonds (even highly rated ones) from sectors that have historically experienced greater defaults, such as multifamily housing and health care.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.