Municipal Bond Risks Lower Than You'd Think

Slate summarizes the data on municipal bond default risks.

Basically, they note that the economy sucks and that this has put great pressure on government budgets that could force them into bankruptcy, ("Vallejo, a city of more than 100,000 east of San Francisco Bay, is currently in Chapter 9."), but the default risk is overwhelmingly concentrated with debts owed by government affiliated entities not backed by tax dollars and even there default rates have been lower than expected.

[H]istorically, their rates of default come in around one-third of 1 percent, far lower than the rates for, say, corporate bonds. Thus, investors around the world own about $2.8 trillion in American municipal debt—an amount that has more than doubled in the last decade and increased about 35 percent over the course of the recession. . . .

Municipalities issue two main classes of bonds. One comes with a "general obligation" pledge, meaning that the government agrees to raise taxes or take other measures to pay bondholders back. But they also issue riskier "non-GO" bonds, or revenue bonds—often to fund the construction of things like hospitals, universities, and housing complexes. It's those bonds where the defaults happen, for the most part. According to Moody's Investors Service, between 1970 and 2009, municipalities have defaulted on Moody's-rated debt only 54 times, and 51 of those defaults came from bonds to finance things like housing projects. . . .

[D]efaults on non-GO debt—for things like hospitals and housing projects, debt already considered more risky—are happening at a slower rate than in years past. The National League of Cities notes that there have been at least 72 defaults this year, down from 204 in 2009 and 162 in 2008. Considering the thousands of bonds issued in the last decade by the 50 states,19,000 cities, 4,000 counties, 15,000 school districts, and tens of thousands of individual projects—that's not too bad.

Thus, there have been only three non-housing project related municipal bond defaults of Moody's rated debts in the last four decades. Tax backed debt default rates remain miniscule.

The low default rates also cast doubt on the proposition that higher corporate bond default rates are due to unavoidable bad luck as opposed to predictable risky decision making. Municipal bonds not supported by tax revenues involve large, complex enterprises that are influenced by the economy. Yet, somehow, they manage to avoid the default rates seen in the for profit private sector.