Muni Bonds: Riskier Than You Think

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Investors generally view municipal bonds as safe investments—and the figures seem to back that up. Moody’s Investors Service tracked just 71 muni bond defaults from 1970 to 2011. A new analysis from the Federal Reserve Bank of New York says there’s an “untold” story of muni bonds—that they actually go bad much more than we thought.

There’s a discrepancy because many muni bonds aren’t graded by the two large rating companies, Moody’s and Standard & Poor’s, and therefore don’t show up in their data. When researchers included unrated bonds, they found 2,521 soured deals from 1970 to 2011—more than 35 times what Moody’s found in the bonds it tracked.

That makes sense, because unrated bonds may be more likely to default. “Rated municipal bonds tend to be self-selected: issuers are less likely to seek ratings if their municipal bonds are not likely to achieve investment grade ratings,” the researchers wrote.

With so many more defaults to examine, the researchers were able to reach some conclusions about what causes deals to go bad. Few defaults came from general obligation bonds—those backed by broad tax revenue—or bonds backed by revenue sources like utility payments that are essential services. Bonds backed by revenue sources that aren’t critical or tested defaulted more often, researchers found. Twenty-eight percent of the defaults were from so-called industrial development bonds, which are sold to finance projects such as alternative energy plants. Bonds repaid by revenue from nursing homes, housing, and hospitals were problematic, too.

While default rates on corporate bonds tend to rise during economic downturns, the researchers found no similar pattern for municipal bonds. They suggested that “idiosyncratic” issues or events cause those defaults. As we wrote in July, the three California cities that filed for bankruptcy this year all did so for very different reasons—reckless spending in one case, a soured deal for another, and pension obligations and possible false reporting in a third.

The Washington Post notes that unrated bonds are generally sold to professional investors rather than individuals. But if they default, someone’s always stuck holding the bag. And that’s happening more often than we knew before.

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