How Safe Are Municipal Bonds?

Partly because of bank analyst Meredith Whitney’s forecasts, and partly because of increasing concern about the strained finances of many issuers of municipal bonds, the media continues to focus on the presumed riskiness of municipal bonds.

• The main deterrent to default is that issuers of muni bonds cannot just go out of business and liquidate themselves. Large issuers of municipal bonds depend on those bonds to fund critical continuing operations and capital budgets. A default that would shut off access to capital markets is simply not an option.
• Issuers of municipal bonds set aside very clear sources of revenue for debt service. For most issuers, debt service is paid off over long periods of time (as long as 30 years); in addition, debt service constitutes a relatively small portion of total expenditures (4% to 8%).
• Only 26 states allow municipalities to file for bankruptcy. Moreover, municipal bankruptcy is a very complex process.
• Default rates among issuers of municipal bonds are extremely low—about one-third of 1%.
• In general, riskier bonds fall into several well-known and clearly defined sectors. Two examples are private-purpose bonds, such as developments for nursing homes, and tobacco bonds.

Analogies between the credit quality of muni issuers and the debt problems of European sovereign countries or corporations are totally misplaced. And while there will no doubt continue to be some individual defaults, the perception among industry veterans is that the credit quality of the muni sector is likely to remain high. Clearly, if you are buying individual bonds, you need to investigate sources of revenue and credit quality. But given the overall low default rate of the sector and the diversified nature of bond funds, for most muni bond funds, credit quality ought not to be a major concern.

Source: American Assn of Individual Investors

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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