Cumulative default rates were found to be lower for bonds issued after Fitch attributed this to the Tax Reform Act of which restricted the issuance of tax-exempt debt, particularly poor performing industrial development bonds , better disclosure, better financial management practices by issuers, greater scrutiny by different stakeholders, and improved economic conditions, including lower interest rates, which lowered the cost of borrowing.
Default rates, however, varied significantly across municipal sub-sectors, even though the overall rate was low compared to many fixed-income sectors.
The study found that the 16 to 23 year cumulative default rates for tax-backed and traditional revenue bonds were less than 0. Industrial revenue bonds had a cumulative default rate of These three sectors accounted for 8 percent of all bonds issued but 56 percent of defaults. Education and general-purpose sector bonds accounted for 46 percent of issuance but only 13 percent of defaults. One of the new findings in the study was that there was a moderate correlation of default risk with economic cycles, though a one-year lag produced a higher correlation.
During the early s and the early s when economic growth was slow, default rates were the highest. Another new finding was that defaulted municipal bonds have a fairly high recovery rate of Recovery can be made in a couple of ways. The borrower may get out of the default situation by making full debt service payments or collateral securing the bonds may be liquidated. Most issuers, particularly providers of essential services such as water and sewer, resume paying debt service.
These types of securities are backed by physical assets that are public property. Thus they are never pledged to bondholders. In such cases, bondholders maintain a lien on revenues, which often enables full recovery. Industrial development bonds and multifamily housing bonds, the two sectors with the highest default rates, are often backed by collateral leading to higher than average recovery rates.
The new trend was arising out of conditions faced by most local governments across the nation at the time. Many small issuers had entered the leasing market in the mids and governments began to test their abilities to make lease payments from operating revenues as those projects were just coming into use in the early s. Faced with difficult fiscal situations and less than anticipated revenues from projects financed with bonds, many municipalities began to question whether they should continue to make lease payments on their outstanding debt.
A downgrade usually means higher interest rates, which in the long run can make borrowing prohibitively expensive. Investors rely on credit ratings, which indicate the probability of default. A high credit rating indicates a low probability of default and vice versa. Both municipal bonds and corporate bonds are rated by rating agencies that specialize in evaluating credit quality.
The Fitch study of municipal debt defaults was followed by a revision of its rating criteria for many sectors of public finance. The study concluded that management practices were more important for predicting credit performance than had been thought in the past. The three most important management practices identified that led to stronger credit and lower defaults were: Superior disclosure Maintaining rainy day funds or operating reserves Implementing debt affordability reviews and policies.
Generally, insurers do not recommend or require ratings from any particular rating agency. The issuer must determine which, if any, ratings it will purchase for the insured bonds. The issuer is also responsible for paying the rating fee to each rating agency that assigns ratings to the bond issue. While a bond issue may be insured by only one rating agency, if the insurer's rating is reduced by any rating agency, the market value of the bonds could be affected.
Assessing Feasibility. In a direct purchase, the issuer determines the feasibility of acquiring insurance. This requires an analysis of the projected interest cost differential for uninsured bonds compared to insured bonds. The interest cost savings should be more than sufficient to offset the cost of the insurance premium. Furthermore, since the premium is paid at the time of the bond closing and interest cost savings if any are realized over the term of the bonds, a present value analysis is the preferred approach for determining whether insurance results in cost savings.
Role of WM Financial Strategies. For your municipal bond issue, WM Financial Strategies will explore the feasibility of obtaining a municipal bond insurance policy. WM Financial Strategies begins with an analysis of your credit condition, the issue structure and current market trends. If, the acquisition of insurance appears to be feasible, WM Financial Strategies applies for a municipal bond insurance policy from one or more of the insurers listed above that maintains a high credit rating.
If the issue qualifies for insurance, a recommendation whether to buy insurance is made based on the analysis described above see "Assessing Feasibility". Due to the loss of demand for bond insurance, insurers that do not have subprime exposure have also come under review.
The table below is a summary of credit rating actions relating to insurers that were AAA rated prior to December For a more detailed description of actions taken since October see Bond Insurance and the Great Recession. Louis, Missouri Phone JHoward munibondadvisor. Nothing contained herein should be viewed as investment advice or as constituting a recommendation to buy, hold or sell the obligations referred to herein. The higher credit rating enables the bond issuer to pay a lower interest rate on the bonds when they are sold.
There are four major agencies that provide bond credit ratings. These agencies are the following:. Insuring a municipal bond also increases the bond's marketability. The insurance helps smaller issuers who are unknown or do not issue bonds frequently to be taken seriously by investors. Municipal bond insurance companies guarantee that the interest and principal of a municipal bond will be paid on time if the bond issuer is unable to do so.
In the event of a default, the insurance company makes the payments to ensure that investors receive their principal and interest earnings promptly. This guarantee generally lasts for the entire life of the bond and cannot be canceled by the insurer. An exception to this rule is in the case of unit investment trusts. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content. Create a personalised content profile.
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Develop and improve products. List of Partners vendors. If your primary investing objective is to preserve capital while generating a tax-free income stream, municipal bonds are worth considering. Municipal bonds munis are debt obligations issued by government entities. When you buy a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period.
At the end of that period, the bond reaches its maturity date , and the full amount of your original investment is returned to you. While municipal bonds are available in both taxable and tax-exempt formats, the tax-exempt bonds tend to get the most attention because the income they generate is, for most investors, exempt from federal and, in many cases, state and local income taxes. Investors subject to the alternative minimum tax AMT must include interest income from certain munis when calculating the tax and should consult a tax professional prior to investing.
Municipal bonds come in the following two varieties:. General obligation bonds , issued to raise immediate capital to cover expenses, are supported by the taxing power of the issuer. Revenue bonds, which are issued to fund infrastructure projects, are supported by the income generated by those projects. Both types of bonds are tax-exempt and particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts.
Although buying municipal bonds is low-risk, they are not entirely without risk. If the issuer is unable to meet its financial obligations, it may fail to make scheduled interest payments or be unable to repay the principal upon maturity.
Bonds rated 'BBB', 'Baa', or better are generally considered appropriate investments when capital preservation is the primary objective. To reduce investor concern, many municipal bonds are backed by insurance policies guaranteeing repayment in the event of default.
Every year, Moody's Investors Service publishes "U. Municipal Bond Defaults and Recoveries," a proprietary study on more than 10, municipal bond issuers it covers. The most recent study covers defaults from to Over the past 10 years, the average default rate for investment grade municipal bonds was 0.
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