From the Fixed Income Desk at The BAM ALLIANCE
Q: What kind of risk is present in municipal bonds?
A: A lot of municipal credit risks were exposed when the financial crisis hit in 2008, with municipal insurance companies failing, merging or getting downgraded. This brought scrutiny to the municipal market as some investors began to question the safety of muni bonds. It’s important, however, to remember that not all municipal bonds carry the same amount of risk. The market, after all, offers a variety of types and legal pledges.
There are two main types of municipal bonds: general obligation and revenue bonds. General obligation bonds carry the full faith and credit of the issuing municipality and are typically paid through property taxes. Revenue bonds, which cover sectors such as water, sewer and education, are funded by the revenues of that specific project and typically do not carry the full-faith backing of the municipality.
With revenue bonds, certain projects are more essential than others. Projects like water and sewer systems or public university improvements are considered essential in purpose. No matter the state of the economy or project itself, a municipality cannot afford to default on these types of programs because they are vital services for a community. However, projects such as housing and health care systems tend to have limited purposes and recourses and are generally not viewed as being essential services. Therefore, municipalities are much more likely not to intervene when these projects become insolvent. This is shown in the default table below. As you can see, housing and health care projects make up the vast majority of municipal defaults over the past 40-plus years. Defaults in general obligation and essential service revenue bonds remain rare occurrences, as evidenced by the default statistics for education, cities/counties/states and water/sewer projects.
Municipal Default by Sector, 1970–2012SECTOR# of Defaults%Housing2939.70%Hospitals/Health Svc. Providers2230.10%Infrastructure45.50%Education34.10%Cities34.10%Utilities22.70%Water & Sewer22.70%Counties22.70%Special Districts00.00%State Governments00.00%Pool Financings00.00%Other11.40%
Bottom line: We don’t believe in taking risks with fixed income. We focus on high-credit-quality general obligation and essential service revenue bonds, such as water/sewer, university revenue and highway/transportation. These sectors have historically shown low-default rates. On the other hand, we strictly avoid unstable sectors such as health care, housing and industrial development.
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