Understanding Muni Bond Defaults and Their Risks

Muni bond defaults can be a significant concern for investors. According to data from 2020, there were 14 municipal bond defaults, with a total default amount of $1.4 billion.

Investors often assume that muni bonds are risk-free, but the reality is that defaults can and do happen. In fact, the National Federation of Municipal Analysts reports that the number of muni bond defaults has been increasing over the past few years.

A single default can have a ripple effect, impacting not only the investor but also the local community that relies on the bond's proceeds. For example, the city of Detroit's 2013 bankruptcy filing led to a significant default on its muni bonds.

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Muni bond defaults can be a real risk for investors. The 5 biggest muni bond defaults in the US are a sobering reminder of this.

Jefferson County, Alabama, is one of the largest muni bond defaults in history, with its sewer revenue bonds going into default in April 2008. The county filed for bankruptcy protection in 2011.

Washington Public Power Supply System's bonds issued to finance a nuclear power plant defaulted in August 1983 due to cost overruns and declining demand. Bondholders recovered about 40% of their principal and interest about a decade later.

The Las Vegas Monorail Corp. defaulted on its bonds in January 2010 due to mechanical problems and lack of ridership. Subsequently, Ambac, which had insured the bonds, filed for bankruptcy.

Stockton, California, defaulted on a number of bond issues in February 2009 due to a building spree cut short by the recession. The city filed for bankruptcy reorganization in June 2009.

Harrisburg, Pennsylvania, fell into technical default in 2009 after failing to honor payment guarantees made to investors in a troubled incinerator project. Investors were protected thanks to bond insurance and reserve funds.

Municipal bonds can be a complex investment, and understanding their ratings and risks is crucial for making informed decisions.

Credit ratings play a significant role in determining the default probability of municipal bonds. Traditional municipal sectors such as transportation, public utility, healthcare, multifamily housing, and industrial development sectors have varying credit ratings that impact default rates.

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The credit ratings of senior-lien and subordinated debt issued by municipal electric utilities in specific states can also have a significant impact on default probabilities.

Here's a breakdown of the different credit ratings and their corresponding default probabilities:

Observable yields and yield spreads of municipal bonds with different credit ratings can also provide valuable information about default risks. A higher yield spread often indicates a higher default probability, while a lower yield spread suggests a lower default risk.

Third-party bond insurance can also impact default probabilities, but it's essential to understand that it's not a guarantee against default.

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Historical lifetime default rates of municipal bonds are a crucial factor in determining credit ratings. These rates can vary significantly depending on the type of municipal sector, with transportation and public utility entities having different default rates.

Traditional municipal sectors such as transportation, public utility, healthcare, multifamily housing, and industrial development sectors all have unique default rates. For example, transportation and public utility entities tend to have lower default rates compared to healthcare and multifamily housing entities.

For another approach, see: Current Muni Bond Rates

Credit ratings of senior-lien and subordinated debt issued by municipal electric utilities in specific states are also an important consideration. The relationship between third-party bond insurance, credit ratings, and default probabilities of municipal bonds is a complex one.

The observable yields and yield spreads of municipal bonds with different credit ratings can provide valuable insights into their creditworthiness. A study of market data on single-named credit default swaps (CDS) and a tradeable index of municipal CDS (the Markit MCDX Index) can also help analysts assess the credit risk of municipal bonds.

Here's a breakdown of the different types of municipal sectors and their default rates:

Covenant Living is a company that has been featured in this article, highlighting its involvement in the ratings and risks discussion.

Moody's, a well-known credit rating agency, has also been mentioned in the article, emphasizing its role in assessing the creditworthiness of companies.

Municipal Market Analytics is another company mentioned, providing valuable insights into the municipal bond market and its associated risks.

Welltower, a real estate investment trust, has also been featured in the article, illustrating its connection to the ratings and risks landscape.

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Investors can mitigate muni bond default risk by diversifying their portfolios with a mix of bonds from different issuers and industries.

Diversification can also help reduce the impact of a default on the overall portfolio, as a single default does not have a significant effect on the overall value.

Investors should also consider the credit rating of the issuer, as lower-rated bonds are more likely to default.

Lower-rated bonds often offer higher yields to compensate for the increased risk, but this can also increase the potential for losses.

A well-diversified portfolio with a mix of high- and low-rated bonds can help balance risk and potential returns.

Investors should also pay attention to the issuer's financial health and ability to pay debt obligations.

In some cases, a default may be triggered by a decline in the issuer's credit rating, which can lead to a decrease in the bond's value.

Investors should regularly review their portfolios and rebalance as needed to ensure they remain aligned with their investment goals and risk tolerance.

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