Despite highly publicized ‘defaults,’ they remain a key element in a portfolio
By Dave Homan
Investing in municipal bonds is appealing to many investors because interest income is typically exempt from federal taxation and, if the investor resides in the state of issuance, state and local taxation as well. As with all investments, the interest received from investing in municipal bonds comes with some risk:
- Interest Rate Risk – When interest rates rise, bond prices fall; the longer a bond’s maturity, the more sensitive it is to this risk.
- Reinvestment Risk – The risk that the principal and interest payments will be reinvested at a lower interest rate should rates fall.
- Credit Risk – The risk that you may not receive interest and/or principal payments on a timely basis, also known as a “default”.
Today’s attention in the municipal bond market is largely devoted to the increasing risk of default, with headlines that include “Detroit Rattles Muni Market” or “Muni Default Rate Triples in Past Five Years”. There’s no doubt Detroit’s July bankruptcy and largely publicized municipal bond default has sparked fear and concern with regard to the credit worthiness of a municipal bond investment, but let’s take a closer look:
Municipal bond default rates have increased since the 2008 financial crisis from an average of 1.3 defaults per year (1970-2012) to 4.6 defaults per year. However, with approximately 16,000 US municipal rated bonds the default rate remains extremely low at only 0.03% per year over the last 5 years.
Not all definitions of default and types of municipal bonds are created equal.
A “default” can range from a single delayed interest payment to an outright failure to return any principal. According to Moody’s*, the average recover rate for a municipal bond default is 65 percent for the period 1970-2011. A 2008 bankruptcy in Vallejo, resulted in a municipal bond “default,” but bondholders eventually recovered 100 percent of their original investment as well as the interest.
Types of Municipal Bonds:
- General Obligation (GO) Bonds: Principal and interest are secured by the full faith and credit of the issuer and the issuer’s unlimited or limited taxing power; including income taxes, property taxes, sales taxes, etc.
- Revenue Bonds: Principal and interest payments solely from the revenue generated by the funded project; including bridges, power systems, water systems, hospitals, etc.
According to Moody’s, a leading provider of credit ratings, research and risk analysis of the 71 municipal bond defaults during the period 1970-2011, 93 percent of the defaults were revenue backed bonds with the vast majority (77 percent) of defaults attributed to the health care and housing sectors. GO bonds have accounted for only five of the 71 defaults.
As noted above, the effects of the financial crisis and recession are still prevalent, and we may continue to see persistently higher default rates in the near term. Nevertheless, there are several reasons to believe municipal defaults are likely to remain rare and isolated events, and not the beginning of a systematic wave of new defaults:
- Most municipalities are not exposed to refinancing risks; the majority of municipal debt is structured as long term, fixed-rate bonds with level debt service requirements including principal amortization.
- Debt service typically represents a low percentage of municipal expenditures, which for local governments averages between 5% and 7%, so that defaulting on debt would not address the major budget pressures confronting a stressed municipality.
- Incentives to avoid default remain high, as local governments would face much higher borrowing costs, or risk losing market access altogether, including the short-term note and bank-lending markets which help them bridge cash flow gaps.
- Municipal bankruptcy is itself rare; given the significant legal hurdles to file for bankruptcy protection it’s expected the number of bankruptcy cases each year to remain low.
- Investors in California state GO bonds remain protected as the state’s constitution requires “priority payment,” second only to payment of K-12 education costs.
Municipal bonds still present attractive yields on a tax-exempt basis, especially given increases in federal tax rates, increases in California state tax rates for top earners, and the new 3.8 percent tax on investment income (married joint filers with more than $250,000 in income or single filers with more than $200,000). Investors concerned about credit risk should focus on high-quality, broadly diversified municipal bond funds with low expense ratios.
Not only are municipal bonds attractive investments as part of a diversified portfolio, but municipal bonds provide residents the opportunity to invest in their communities to help finance schools, hospitals, roads, and other essential infrastructure projects. Municipal bonds are a proven, decentralized investment option that keeps the decision making at a local level in partnership with their residents.
Dave Homan, CFP, is a Certified Financial Planner with Willow Creek Wealth Management, Inc., Sebastopol, one of the leading wealth management firms in California. For more information visit www.willowcreekwealth.com or call 707/829-1146. Wealth Matters is a monthly column from the firm’s advisors.
Copyright © 1988–2013 North Bay Business Journal
View the policy for linking to website content.