Why Municipal Bond Defaults are Higher Then You Think

Municipal bond defaults in the United States have attracted plenty of discussion recently.

With Stockton, Harrisburg and Jefferson Counties all going bankrupt in 2012, muni bond buyers are nervously eyeing where the next default will occur.

Hit by the recession, municipalities have seen declining property taxes, growing unemployment and diminished reserves straining their already stretched balance sheets to breaking point.

However, despite recent headline defaults, muni bonds have enjoyed a confidence born from historically low default rates, especially when compared to their riskier private sector cousins, corporate bonds.

For instance, Moody's reports that between 1970 and 2011, only 71 of the municipal bonds it rated defaulted, while S&P records only 47 such defaults between 1986 and 2011.

Corporate bond defaults, over a different but statistically comparable time period, were 1,784 and 2,015 respectively.

But, according to the Federal Reserve Bank of New York, these numbers don't tell the whole story.

When they examined the number of un-rated bond defaults -- merging data from the big three rating agencies and un-rated muni bond trackers Mergent and S&P Capital IQ -- the number of defaults jumped significantly.

Moody's 71 defaults (1970 to 2011) became 2,521 over the same period, a 36 fold increase.

S&P's 47 defaults? Well, that grew to 2,366.

The New York Fed put this down to two main reasons. First of all, the process of rating bonds is self-selecting; riskier bond issuers won't seek agency approval if they know they won't receive an invest grade rating. Secondly, not all bonds are created equal.

General obligation bonds rely on the broad tax raising ability of the municipality. Revenue bonds, on the other hand, can only call on the revenues raised by a specific enterprise, such as a school, hospital or airport.

Lastly, the Fed's report noted that, historically, muni bonds have no discernible pattern for defaulting, unlike corporate bond defaults which spike during a recession.

"The absence of a clear pattern leads us to believe that municipal bond defaults may be more a function of idiosyncratic factors associated with individual sectors or issues than the result of broad macroeconomic developments," the report noted.