With any investment, you need to be aware of the risks involved. A question we’re asked often is, “If I’m investing in the city, how do I know I’ll get my money back?”
The good news is that defaults in muni bonds are very rare. For example, did you know that no state has defaulted on a general obligation bond since 1933? Even better, the only two states that defaulted in 1933 eventually paid back all the overdue principal. Compare this to the stock market — where in the Great Recession of 2008, the market dropped over 57% — and muni bonds look that much more reliable as investments.
But what does it mean if a city defaults on its debt? How does it happen, and how would it affect you as a bond holder? In this article, we’ll explain how and why muni bonds default and how you can keep the risks you’re taking at a level you’re comfortable with.
Why Muni Bonds Default
Understanding what causes bond defaults can help you make smart investment decisions. At the most basic level, muni bonds default when their issuers — states, cities, or communities — find themselves unable to repay their debts in a timely fashion. On the rare occasion that a muni issuer does default, the problem can often be traced back to issues such as:
Poor project and resource management
Inflated government salaries, pensions, and benefits that draw on limited funds
Financial mismanagement and fraud
By keeping tabs on investments and performing due diligence on the operations and finances behind a given bond issuer, you can help protect yourself against losses.
Some Default Statistics
Before we dive into the positive stats behind muni bond defaults, let’s just get one thing out of the way: muni bonds are not immune to defaults. In fact, you probably remember that back in 2013, Detroit defaulted on its bonds when the city filed for bankruptcy. In the grand scheme of munis, however, Detroit is by far the exception, not the rule. And since Detroit’s bankruptcy filing, no U.S. city or county has commenced a Chapter 9 bankruptcy process.
Here are some more impressive facts about muni bond defaults:
Of Moody’s 71 reported defaults, only 5 stemmed from general obligation bonds.
Municipal bonds are 50 to 100 times less likely to default than comparably rated corporate bonds.
Since 1933, there has not been a single state general obligation bond to default. Prior to the Great Depression, the only other state defaults on record can be traced back to the period of the Civil War.
Just because a bond issuer defaults on a payment doesn’t mean that all is lost. A default doesn’t cancel out a bond or make the issuer’s obligation to repay you go away. Owning bonds that go into default is never a desirable situation, but as an investor, it pays to focus on recovery.
When it comes to munis, the recovery rate — the extent to which bondholders end up collecting what they’re owed following a default — for general obligation bonds is close to 100%. The reason is that with a general obligation bond, the issuer is allowed to use its full taxing power to raise enough money to repay bondholders. A city faced with a financial crisis, for example, can increase property taxes to make good on its debt obligations.
Historically, municipal bond recovery rates have been pretty high overall — about 60% on average between 1970 and 2013. The rate for corporate bonds, by contrast, was only 48% between 1987 and 2013. And while a large percentage of defaults over the past 40 years stemmed from the housing and healthcare sectors, in many cases, investors were made whole and ultimately saw recoveries of 100%. Even Detroit — a city that has come to epitomize economic catastrophe — saw a 74% recovery for holders of the city’s general obligation bonds.
Another thing to keep in mind is that bond insurance can help reduce the losses associated with a default. Though not all municipal bonds carry insurance, those that do offer investors an added layer of protection against financial losses in the event of a default, as insurance companies are required to make payments when their bond issuers cannot.
Weighing the Risks
If you’re thinking of investing in municipal bonds, you may be concerned about defaults, but remember this: Based on the historical data we’ve reviewed, it’s clear that muni bonds tend to be less volatile than most other investment vehicles. And even if a bond ends up defaulting, You may still receive some or even all of the return you expected. In our next section, we’ll review some scenarios where investing in muni bonds might make sense. You can also visit Neighborly to read more from this series, learn more about how munis work and search for investment opportunities in your area.