Analyzing Historical Municipal Bond Defaults

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Municipal bond owners worry about their bonds defaulting. When a bond defaults, interest payments get interrupted and you may never see return of principal.  It is prudent to understand the past to avoid future problems. An average of eight municipalities defaults occur every year, although more will probably start to appear in 2011.

Great Depression

One of the worst periods in the markets history, the Great Depression saw its worst year in bonds in 1935. 1.8% of issuers were in default. Interest or principal payments were late or missing 1.7% of the time from 1929 to 1937. Only 0.5% of the interest or principal payments were still lost by 1937. The average default rate was 97%. From 1929 to 1939 the pretax annualized return on municipal bonds was a very good 5.1%. Some argue that municipalities were in better shape before the Great Depression then they were during the Credit Crisis.

1841 Defaults

In 1841, a depression occurred and nine states defaulted on their debts. Most of the states eventually paid off their debts, but Mississippi still has not. Laws were changed to increase safeguards after this situation, and new borrowing was clamped down upon. Congress in 1843 rejected a bailout plan, worried that were caused recklessness and extravagance among states. Taxes were increased significantly to pay for infrastructure and meat debts. Indiana and Ohio soft property taxes go up eightfold. Yield’s on state bonds increased from 12% to almost 30% by 1842. It is clear that government needs taxpayers to approve tax increases as a direct result of making new loans. It is currently harder to raise taxes meant to raise expenditures.

Municipal Bond Default Rates

Analysis from Moody’s Investors Service indicates that the default rate from 1972 to 2009 is 11.1% for corporate bonds, 0% for AAA municipal bonds, 0.03% for AA-rated municipal bonds, 0.03% for A rated municipal bonds, and 0.16% for Baa space rated bonds. The default rate was 3.4% for lower rated bonds. Unrated bonds have a higher default rate. Clearly the default rate will rise after the credit crisis, possibly to the 1 to 2% range.

A December, 2010 report from Bank of America Merrill Lynch indicated that there was $4.25 billion of municipal debt in default, representing only 0.15% of the entire municipal bond market. For 2010, new municipal bond defaults amounted to $2.7 billion or about 0.09% of outstanding issues. Nearly all the defaults were for unrated bonds.

Unrated and Non-Investment Quality Bonds

Many of the municipal bond defaults occurred in so-called unrated municipal bonds and non-investment quality municipal bonds. Obviously avoiding this area is recommended. Investors are attracted by the high interest rates these municipal bonds yield. Remember the bond portfolio should be one of the safest parts of your portfolio. Municipal debt backed by appropriation pledges is equivalent to an unsecured creditor.

Chapter 9 Municipality Bankruptcy

If a municipality is financially troubled or simply runs out of money, they can declare Chapter 9. The bankruptcy law is hazy on how far a municipality can go in re-architecting pensions for current retirees. Bondholders are not insulated from loss. 26 states do not allow their municipalities to file bankruptcy. In other areas, the city must demonstrate that it is technically insolvent. Chapter 9 remains a largely untested area of the bankruptcy code. Unfortunately it will probably yet tested heavily in 2011 as municipalities fail. States cannot file for bankruptcy.

In 2009, ten municipalities filed bankruptcy. In 2010 the number was five. Since 1930, 600 cases of bankruptcy have arisen. More municipalities in the near future may file for bankruptcy due to the Credit Crisis of 2008. With bankruptcy, legal and consulting fees will cost municipalities great deal of money.

Since 1981, of 43 municipal bankruptcy, 33 were dismissed by the judge when trying to discharge their debt, and the remaining 10 did not list the final outcome but none had the principle owed reduced. The 2008 Vallejo bankruptcy was the first that sought to cut the interest rate paid to its lenders.

Riskier projects

Some of the projects that have the most defaults include: nursing homes, long-term care facilities, apartment buildings, toll roads, museums, stadiums, real estate developments, land, housing, not for profit hospitals, and high risk real estate.  According to Moody’s of 54 defaults from 1972 to 2009, 78% were in standalone housing and healthcare.

Of the defaults on municipal bonds rated by Moody’s from 1972 – 2009, here is the breakdown:

  • 21 in housing
  • 21 in health care
  • 4 City, town, county non-general obligation
  • 3 electrical, water, or sewer utility
  • 3 general obligation
  • 1 higher education
  • 1 recreation

Municipal bond areas with the highest default rates are Community-Development districts, assisted living, independent living, nursing homes, and telecom.

Late Financial Statements

Municipalities or projects that produce late financial statements are more likely to default. Look for bonds with material events or ME flags as warning signs. Unfortunately material event notifications can occur months after the event, and there is no consequence for failing to report material events. And enforcement system should exist. You can look up material events for a specific bond on msrb.org by entering its CUSIP number and clicking on Continuing disclosureMaterial event notices.

Tobacco Bonds

Tobacco bonds are backed by payments made to the state government by tobacco companies. These statements are based on projected cigarette sales. The problem is that cigarette consumption keeps dropping, making the original projections way out of whack. This leads to fears that defaults could occur.

On November 11, 2010, Standard & Poor’s downgraded $22 billion of tobacco bonds to junk status, mainly those with lower coverage levels that make them more susceptible to declines in smoking. This led to a significant yield rise in municipal bonds and a fall in prices.

Las Vegas monorail

Las Vegas monorail is a high profile project that has run into problems due to poor revenue. Even though the bonds were insured, insurance company is having trouble itself to just stay afloat.

Vallejo, California

Vallejo is a city about 30 min. north of San Francisco, which had outstanding debt, and declared Chapter 9 bankruptcy in May 2008. This is the second largest municipal bankruptcy filing in California. The police and fire unions salary and benefits took up roughly 80% of the city’s budget. The city owes more than $50 million and has just $5 million to pay them back. Vallejo Municipal bonds have been on hold while the city works out a restructuring plan.

Right now it looks like no interest would accrue through 2013, and general fund principal and interest payments would be suspended through 2013, although more pain may occur. Most original holders of insured Vallejo municipal bonds have been paid in full or will be. Owners of water or sewer revenue bonds are entitled to payments under bankruptcy law provisions.  As long as revenue continues to be collected. General obligation and other bond holders may not be paid in full.

The city, California state controller, and the bond insurer, agreed that in event of default, the insurer could access some of the funds that California distributes local governments.  This is significant because it upholds the right to access to money that helps backstop many municipal bonds.

The city did not reduce pension payouts for current retirees, only new employees, in its reorganization, although it did propose trimming workers and retirees health care benefits. This goes to show that expensive contracts and pension benefits do not necessarily get trimmed in Chapter 9. Often times lawyers are the ones that make out in the end of any long battle. Vallejo did uphold its bankruptcy right to reject collective-bargaining agreements with unions in a 2009 court decision.

Stockton, California

Stockton, California declared Chapter 9 Bankrupcy on Thursday, June 28, 2012. The biggest city in America to file bankrupcy is now Stockton. Their problems were caused by the forclosure crisis, expensive retiree benefits, and millions spent on civic improvement projects. They have tried to make ends meet by slashing their budget, laying off police and other city employees. All payments were suspended to bond holders and other holders of long term debt. They have nearly $1 billion in long term debt.

Orange County, California

Orange County, California declared bankruptcy in 1994. Roughly $2 billion was owed. Investors eventually were made whole on Orange County bonds, although county taxpayers will continue to pay off their refinanced IOUs for two more decades.

Menasha, Wisconsin Steam Plant

Wisconsin‘s steam plants that issued municipal bonds are in trouble and the city is trying to walk away from its obligations. This is another case of a risky project dependent on the new plant and specific customers.

Harrisburg, Pennsylvania

Harrisburg filed for Chapter 9 Bankruptcy Protection in Oct. 2011. They were saddled with a huge $400 million debt tied to a trash burning incinerator. Bond holders and the city could not negotiate a settlement to avoid bankruptcy. There have been 48 bankruptcies from cities, counties, and towns since 1980.

Jefferson County, Alabama

Jefferson County, Alabama filed for bankruptcy in November 2011 with $3 billion of debt. Their major problem was a failed sewer deal. This is the largest municipal bankruptcy yet. Their exotic refinancing deals with large Wall Street banks backfired and resulted in 20 Alabama officials, contractors, and others to be convicted of fraud.

Related Municipal Bond articles:

Analyzing Municipal Bond Defaults

Are we in a bond bubble?

Municipal Bonds are Bad Investments

Municipal Bonds Are a Good Investment

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