The primary concern of all bond investors is whether they will ultimately get their money back. This is especially the case with municipal bond investors: Municipal bond investors willingly accept lower yields compared to other fixed income investments primarily due to the safety record of municipal bonds.
When an issuer fails to live up to the payment obligations of a particular bond issue, the bond is considered to be in default. However, when an issuer misses an interest payment or fails to pay back the principal on the scheduled date, this does not necessarily mean that the investor will not get some or all of their money back. With municipal bond defaults, investors many times get most of their money back. The amount of money that the investor receives from a bond investment that has defaulted is known as the recovery rate.
The 3 largest ratings agencies, Standard & Poor’s, Moody’s, and Fitch Ratings, have each produced a case study examining default risk and recovery rates of municipal bonds. We will summarize the findings from each of these studies below. Investors may also click on the following links to directly access the three studies.
Fitch Ratings:
Default Risk and Recovery Rates on U.S. Municipal Bonds
Standard & Poor’s:
U.S. Municipal Rating Transitions and Defaults, 1986-2009
Moody’s
Moody’s Municipal Bond Rating Scale
http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20pages/Credit%20Policy%20Research/documents/current/2001700000407258.pdf
Summary:
Each of the 3 ratings agencies assigns ratings to various municipal bond issues as a part of their business; the ratings classify credit risk just as an individual’s credit score is used to assess credit risk. Generally, a municipal issuer such as a school district or a state pays the rating agency to have an upcoming bond issue rated. Just as with individuals, the better the credit rating, the cheaper it is for the issuer to borrow money. The ratings agency analyzes the various risk factors associated with a particular bond issue and the issuer. Based on the rating agencies assessment of the risk factor, the issuer is assigned a credit rating (Aaa, AAA, Baa, etc…).
In its 2003 study, Fitch Ratings concluded the following:
Based on two studies released in 1999 and 2003, Fitch reviewed all municipal bond defaults between 1987-2002. Based on the results of its findings, Fitch Ratings came to conclusion that the different types of municipal bonds fit into three categories of default risk….Class 1, Class 2, and Class 3.
Class 1, the safest category, is comprised of most local and state general obligation bonds. Class 1 also includes general obligation and revenue bonds issued by established authorities with no competition or natural monopolies in essential public services. Altogether, Class 1 includes the following types of bond issues:
- State general obligation bonds
- Local general obligation bonds
- Local school districts
- Appropriation-backed and tax-backed debt of local and state governments
- Public power distribution
- Water and Sewer Authorities
- Public higher education
- Single family housing
In this category of issuers, the cumulative default rate between 1987-2002 was .24%; the comparative default rate during this same period for AAA-rated global corporate debt was .43%.
Class 2 from a default perspective is comprised of public service enterprises providing essential services, but where the enterprise is subject to competition or fluctuation in demand. The bonds issued in Class 2 are generally revenue bonds providing services such as:
- Public power generation (as opposed to distribution which is in category 1)
- hospitals
- waste disposal
- private colleges and universities
- military and state multifamily housing
- museums and stadiums
- airports and seaports
- toll roads with established traffic patterns
In Class 2, the five-to-fifteen year cumulative default rate between 1987-2002 was .70%; the comparative default rate during this period for AA-rated corporate bonds was .73%. The types of bonds in Class 2 have a similar default rate to AA-rated corporate bonds according to the Fitch Ratings study.
In Class 3, the issuers are comprised of entities that compete with private enterprises and have highly unpredictable or volatile revenue streams. These types of issuers include:
- Nursing homes and continuing care retirement facilities
- Industrial development bonds
- Local Multifamily housing
- Toll roads without established traffic patterns
- Tobacco bonds
- Tribal gaming
In Class 3, the five-to-fifteen year default rates of 3.65% are comparable to 3.97% for ‘BBB+’ rated corporate bonds.
An interesting assessment made by the Fitch study is that Fitch expects that even if the ratings are similar, a single A-rated airport bond will have a higher expected default rate than a state or school district also rated single A. This should lead an investor to place an emphasis on the type of bond issue being considered in addition to the bond’s rating. Municipal bonds rated similarly can have vastly different characteristics. According to this Fitch study, the type of issuer and issue is as important as the credit rating when evaluating the likelihood of future default.
Recovery Rates:
When a municipal bond defaults, the investor generally will still receive some money back from their investment; this is known as the recovery rate. In some cases and with certain types of issuers, the recovery rate can be as high as 100% or 100 cents on the dollar. In some cases, a temporary default on interest payments can be cured with some late payments from the issuer and the issuer can resume servicing the debt once again according to schedule.
Comparing different categories of municipal bonds to corporate bonds maybe accurate in terms default rates, but the recovery rates are another matter according to Fitch. Corporate bonds have an average recovery rate of about 40% or 40 cents on the dollar.
Fitch in this study creates 6 classes of recovery rates. The first 3 classes are assumed to have recovery rates of 100% of the principal.
Class 1:
- State GO debt
- State sales tax backed debt
In the event of default in this class, Fitch assumes a recovery rate of 100% of the principal amount with an assumed loss of 1-years interest.
Class 2:
- Local general obligations
- Local tax-backed debt
- Transit authorities
- Water, sewer, gas
- Public colleges and universities, GO and tuition-revenue backed
- Single family housing
For Class 2, Fitch assumes a recovery rate of 100% of the principal with 2-years of missed interest payments.
Class 3:
- local and state leases, certificates of participation, and appropriation-backed
- Airports and seaports
- Power distribution
For Class 3, Fitch’s model assumes a recovery rate of 100% with 5-years of missed interest payments.
Class 4:
- Waste disposal
- Nursing homes and retirement facilities
- Private colleges and universities
- Established Bridges and roads
- Museums and stadiums
- Public power generating facilities
- State and local multifamily housing
For class 4, Fitch’s model assumes a recovery rate of 90%.
Class 5
- military housing
- start-up and new bridges and toll roads
For Class 5, Fitch’s model assumes a recovery rate of 70%.
Class 6:
- private prison
- stadiums
- student housing
- private university bonds backed by auxiliary revenues
- hospitals
- tribal gaming
For Class 6, Fitch assumes 40% recovery rates.
Fitch doesn’t explicitly address where many other types of bonds such as industrial development bonds, tobacco securitizations, etc..
Conclusion:
The way an investor would use this information is by being aware of the default risk and recovery rates of various categories of municipal bonds. Rather than simply relying on a rating or a recommendation, information such as this historical analysis from Fitch Ratings should provide you an additional set of data points in helping you understand the risks of investing in municipal bonds.
Investors should be aware that this is simply one analysis done by Fitch Ratings in 2003 and the information should be considered as an educated opinion based on a historical analysis of municipal bond defaults.
