Municipal Bond Default Rates
Municipal bond default rates refer to the proportion of outstanding municipal bonds that fail to make timely interest or principal payments, resulting in a default by the issuing entity. This metric is a key indicator within the broader field of fixed-income securities, reflecting the credit risk associated with debt issued by state and local governments and their agencies. While municipal bonds are generally considered highly secure investments, understanding municipal bond default rates provides crucial insight for investors assessing potential risks and returns.
History and Origin
The concept of municipal debt and the possibility of default have existed for centuries, but systematic tracking of municipal bond default rates gained prominence with the growth of the modern financial markets and the establishment of credit rating agencies. Historically, defaults by municipalities have been relatively rare compared to corporate defaults. For example, between 1970 and 2022, Moody's Investors Service reported only 115 distinct rated defaults across more than 50,000 different state and local government entities and other issuing authorities.26
Significant municipal financial distress events, such as New York City's fiscal crisis in the 1970s and the Orange County bankruptcy in the 1990s, brought attention to the importance of evaluating municipal credit quality. More recently, the bankruptcy of Detroit, Michigan, in 2013, the largest municipal bankruptcy in U.S. history, and the prolonged debt crisis in Puerto Rico, which entered a form of bankruptcy protection in 2017 with over $120 billion in combined debt and unfunded pension commitments, highlighted the potential, albeit infrequent, for large-scale municipal defaults.24, 25 The Detroit bankruptcy demonstrated that even general obligation bonds, traditionally viewed as the safest municipal debt, could be subject to significant losses for bondholders.22, 23 Research from the Federal Reserve Bank of Boston in 2014 examined the Detroit bankruptcy's impact, noting that while there was limited spillover to abnormal yield changes for other municipalities, states with heavy pension obligations and speculative-grade securities did experience statistically significant downward repricing.21
Key Takeaways
- Municipal bond default rates measure the frequency with which municipal bond issuers fail to meet their debt obligations.
- Historically, municipal bond default rates have been significantly lower than those for corporate bonds, underscoring their relative safety.
- Defaults are often concentrated in specific sectors, such as healthcare and housing, or among unrated issues.
- Credit rating agencies provide valuable analysis and statistics on default rates for rated municipal debt.
- Understanding municipal bond default rates helps investors evaluate the credit risk of their fixed-income portfolios.
Formula and Calculation
Municipal bond default rates are typically expressed as a percentage or a ratio, indicating the number of defaulting issues or the par amount of defaulting debt relative to the total number of outstanding issues or total par amount. While there isn't a single universal formula, credit rating agencies calculate default rates based on their rated universe.
For example, a simple default rate could be calculated as:
Alternatively, it can be calculated based on the par value:
These calculations provide a statistical measure of how often a default occurs within a given period or over the lifetime of a bond issue, offering insights into the overall risk profile of municipal bonds.
Interpreting the Municipal Bond Default Rates
Interpreting municipal bond default rates requires context regarding the specific type of bond, the issuer's credit quality, and the prevailing economic conditions. A low municipal bond default rate suggests a strong creditworthiness of municipal entities. For instance, Moody's reported that the average five-year municipal default rate from 1970 to 2022 was 0.08%.20 This compares favorably to corporate bond default rates over the same period.19
Investors often compare the rates of general obligation bonds, backed by the full faith and credit of the issuing government and its taxing power, with revenue bonds, which are repaid from specific revenue streams generated by a project, such as toll roads or utility fees. Historically, general obligation bonds have exhibited even lower default rates than revenue bonds.18 A high credit rating from agencies like Moody's or S&P indicates a lower perceived likelihood of default, guiding investors in their assessment of a bond's yield and overall risk.
Hypothetical Example
Consider an investor, Sarah, who is evaluating two municipal bonds for her portfolio: one issued by a state for a highway project (a type of revenue bond) and another by a city for general government operations (a general obligation bond).
Sarah consults a credit rating agency's report on municipal bond default rates. The report indicates that over the past decade, the cumulative default rate for investment-grade revenue bonds related to infrastructure projects was 0.5%, while for investment-grade general obligation bonds, it was 0.05%.
If there are 1,000 similar investment-grade revenue bonds outstanding, the 0.5% default rate suggests that, on average, five of these bonds might experience a default over a ten-year period. For general obligation bonds, if there are 2,000 similar issues, the 0.05% rate implies only one default, on average, over the same period. This hypothetical scenario highlights the historical safety of general obligation bonds compared to revenue bonds and demonstrates how municipal bond default rates can inform an investor's assessment of relative risk for different types of municipal securities.
Practical Applications
Municipal bond default rates are a critical component of assessing risk in the fixed-income market. Investors and financial advisors utilize these rates to gauge the safety of municipal bonds and to inform diversification strategies within debt securities. Because municipal bond default rates are historically low, they are often seen as a stable component of a diversified investment portfolio.16, 17
Rating agencies incorporate historical default data into their methodologies when assigning a credit rating to new and existing municipal issues. These ratings, along with information available through continuing disclosure via platforms like the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access (EMMA®), assist bondholders in evaluating credit quality. Re14, 15gulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), also focus on municipal securities disclosure to ensure transparency and protect investors.
F11, 12, 13or instance, Moody's observed that for the period 1970-2009, the 10-year cumulative default rate for Aaa-rated municipal bonds was 0%. For Aa and A-rated municipal bonds, it was 0.03%, meaning approximately 3 out of 10,000 issues rated Aa or A defaulted over a decade. Th10ese statistics illustrate the historical reliability of highly-rated municipal bonds.
Limitations and Criticisms
While municipal bond default rates provide a valuable measure of risk, they come with certain limitations and criticisms. A primary critique is that publicly reported municipal bond default rates, often from credit rating agencies, primarily cover rated debt. A 2012 Federal Reserve Bank of New York report suggested that the actual number of municipal bond defaults, including unrated issues, was significantly higher than the figures reported by rating agencies. Fo9r example, while Moody's reported 71 defaults between 1970 and 2011, the Federal Reserve Bank of New York's database indicated 2,521 defaults during the same period, suggesting that a large portion of defaults occur in the unrated segment of the market. Th8is disparity means that the widely cited low default rates might not fully capture the risk profile of the entire municipal bond market, especially for investors who venture into unrated securities.
Furthermore, a default does not always mean a complete loss of principal. Recovery rates, which indicate the percentage of principal and interest ultimately repaid to bondholders after a default, can vary. Th7e unique legal and political landscape of municipal bankruptcies, as seen in cases like Detroit and Puerto Rico, can lead to unpredictable outcomes for different classes of bondholders, challenging the perceived hierarchy of debt repayment. Th4, 5, 6is makes analyzing municipal bond default rates more nuanced than simply looking at a headline number.
Municipal Bond Default Rates vs. Corporate Bond Default Rates
Municipal bond default rates and corporate bond default rates both measure the incidence of default within their respective markets, but they differ significantly due to the fundamental nature of the issuers and their repayment mechanisms.
| Feature | Municipal Bond Default Rates | Corporate Bond Default Rates |
|---|---|---|
| Issuer Type | State and local governments, agencies, and public authorities. | Corporations (for-profit and non-profit businesses). |
| Repayment Source | Tax revenues, government fees, project-specific revenues (e.g., tolls, utility charges). | Company earnings, asset sales, operational cash flows. |
| Historical Frequency | Historically very low. For example, Moody's reported a five-year cumulative default rate of 0.08% for municipal bonds from 1970 to 2022. | 3Historically higher. The comparable five-year cumulative default rate for global corporates was 6.9% over the same period. |
| 2 | Bankruptcy Process | Governed by Chapter 9 of the U.S. Bankruptcy Code, which prioritizes continuity of essential public services. |
| Tax Implications | Often tax-exempt at federal, state, and local levels. | Generally taxable, though some specific corporate bonds may have tax advantages. |
The lower municipal bond default rates reflect the inherent stability derived from governmental taxing power, the essential nature of services funded by municipal bonds, and, in many cases, robust reserve funds. Wh1ile corporate bonds are subject to competitive pressures and economic cycles that can more directly impact a company's ability to generate profit and service debt, municipal entities generally maintain a more stable revenue base. This distinction often leads investors to consider municipal bonds a safer asset class compared to corporate bond issues, particularly for those in higher tax brackets seeking reliable income.
FAQs
What causes a municipal bond to default?
A municipal bond may default if the issuing government or agency faces severe financial distress, such as declining tax revenues, economic downturns, mismanagement of funds, or unforeseen liabilities like unfunded pension obligations. Default can also occur if the specific project funding a revenue bond fails to generate sufficient income.
Are municipal bond defaults common?
No, municipal bond defaults are historically rare, especially for highly-rated issues. Data from credit rating agencies consistently show that municipal bond default rates are significantly lower than those for corporate bonds.
How does a municipal bond default affect investors?
If a municipal bond defaults, investors may experience a loss of interest payments or principal. The extent of the loss, known as the recovery rate, varies depending on the specific circumstances of the default and the outcome of any debt restructuring or bankruptcy proceedings.
Do all municipal bonds carry the same default risk?
No, default risk varies among municipal bonds. General obligation bonds, backed by the issuer's full taxing power, generally have lower default rates than revenue bonds, which depend on specific project revenues. A bond's credit rating is also a key indicator of its perceived default risk.
Where can I find information on municipal bond default rates?
Credit rating agencies such as Moody's Investors Service and S&P Global Ratings publish periodic reports on municipal bond default rates for the bonds they rate. Additionally, the Municipal Securities Rulemaking Board (MSRB) provides disclosure information on its EMMA® website.