Thursday, August 16, 2012

Municipal Bond Defaults

Municipal bonds are a traditional way that moderately rich sorts invest.  The reason is that while the interest rates aren't spectacular, the interest income is exempt is from both federal income tax, and the income tax of the state in which the bond is issued.  (Exception: private activity municipal bonds, which are a way for private firms to get governmental assistance on building problems, are subject to Alternative Minimum Tax.)

If you have $5 million in cash, you can buy a bunch of munis for your state, and get, even now, a 4% return on your investment.  That's miserable, but that's still about $200,000 a year -- and you owe no income tax on it.  I think, with a little restraint, it is possible to live pretty decently on that. :-)

Of course, in exchange for the low interest rate, munis are traditionally considered pretty safe.  But this article  from the August 15, 2012 Washington Post, would indicate that they aren't quite as safe as everyone assumes:

Defaults on municipal bonds for decades have been far higher than reported by rating agencies, bringing into question the true risk of a common investment widely considered to be safe, according to a study released Wednesday by the Federal Reserve Bank of New York.
Economists at the agency counted 2,521 muni bond defaults since 1970, whereas ratings agency Moody’s Investors Service, for instance, reported 71....
Supporters of muni bonds say that despite a few high-profile cases, government securities rarely default. Data from the New York Fed, however, suggests otherwise.
What is important is that the study found that general-obligation bonds, "rarely fail because they are backed by tax revenue."  The bonds that are used to finance various specific projects, and where the repayment of the bond is dependent on a particular facility such as a hospital or stadium, have higher default rates.  The high risk turns out to be "industrial development" bonds, and these "fail at a 28 percent rate."  UPDATE: A commenter at the Washington Post reports that the Fed study actually says that 28% of the defaulted bonds are industrial development munis.  That is a lot more plausible than a 28% default rate.
I have always been a bit skeptical about munis because I worried about default risk.  This gives me increased confidence, however, that general-obligation munis are pretty safe--and the risk is all the others.

6 comments:

Anthony said...

Municipal revenue bonds - the sort which pay back based solely on a specific revenue source are, as the article notes, more likely to default than general obligation bonds. They pay a slightly higher interest rate for just that reason.

A commenter claims that most retail investors don't buy unrated bonds, but I wonder how true that is. If my wife and I sold our rental houses, we might consider putting the $100,000 in profit we might realize into muni bonds. Would the broker only tell us about bonds rated by the ratings agencies, or would he try to sell us higher-yielding, unrated, revenue bonds?

Clayton said...

My only recent experience is with Schwab. Their bond screen doesn't even show bonds that are below investment grade, and that would include unrated bonds. I could see some fly-by-night investment firm pushing you to high yield bonds, especially if they had a bunch that they couldn't get rid of easily.

Several suggestions: don't put all $100,000 in a single bond. Ideally, you would diversify the money across bonds from several different municipalities. Even though it will lose you the exemption from state income tax, it might be worthwhile to diversify across several different states and regions.

James B. Shearer said...

Not sure where you ar getting a 4% return. If you look at Vanguard's muni funds the yields (with expenses added back) range from 2.62% for California to 2.18% for New York. Even their High-Yield Tax Exempt fund is only 2.79%.

This is the SEC yield, the distribution yield may be higher but this does not reflect amortization of bond premiums for bonds currently worth more than par (because interest rates have fallen recently).

Anonymous said...

The Fed study is piece of garbage. See what "Bond Girl" has to say about it. She knows more about munis than the entire FRBNY.

https://self-evident.org/?p=951

Clayton said...

Mr. Shearer: Muni funds have lower returns than holding bonds directly. I bought some Louisiana and Ohio muni bonds last year above 7% yield.

Anonymous said...

"Several suggestions: don't put all $100,000 in a single bond. Ideally, you would diversify the money across bonds from several different municipalities."

It also might behoove you to invest in municipalities with historically Republican administrations. They seem to be doing better financially than historically Democratic cities.