All Hail the Dowager Queen

What she lacks in youthful upside potential, she makes up for in mature dependability: The muni bond's heyday is coming.
December 2000
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Sounds of alarm are coming from the jittery stock market. Investors are starting to sober up and look for ways to preserve the bounty that blossomed during the prolonged up market in stocks. Some people, including this writer, believe that means that bonds are about to have their day. And the most likely bond to be favored will be the one with superior risk characteristics.

That's where our dowager queen, the municipal bond, excels. What she lacks in youthful upside potential, she makes up for in mature dependability: The muni bond has an awesome record for paying bills on time and in full.

Evidence is found on every hand. The rating agencies--those stern keepers of the credit gate--have year in and year out been revising municipal bond ratings upwards. There are now three widely respected agencies--Moody's Investors Service, Standard & Poor's Corp. and Fitch IBCA. Since issuers pay for ratings, the individual agencies are made to stand on their toes in explaining why some credits are thought better than others. Increasingly, the evidence is that traditional municipal bonds--those sold to finance standard municipal activities by established governments--are, with exceedingly rare exceptions, exceptionally low risks. Like the legendary Timex, they keep on ticking, no matter what.

That's not to say all municipals are alike. Some particular types can be risky. But as a recent study of municipal defaults over the past quarter century documents, the traditional muni bond has a repayment record second to none. The study, done by David Litvak and Frank Rizzo of Fitch IBCA and published in the Municipal Finance Journal this past summer, indicates that overall tax-exempt debt had a cumulative default record of less than 1.5 percent for the dollar volume sold over a 20-year period starting in 1977. As the authors point out, the measure of default in this context means a payment delay, which by no means implies the principal or interest on it was not repaid.

The default study found there were vast differences in the default rates among uses of proceeds and that a few big whoppers accounted for most of the damage in some categories. The munis most inclined to default were industrial revenue bonds, those that were sold to build facilities to lease to private firms. Not surprisingly, these bonds, with a 7.5 percent default rate, reflected the higher default rates seen among non-investment-grade corporate bonds. They were followed by multi-family housing (4.8 percent default rate) and both health care and nursing homes (1.6 percent). These "private-activity" bonds are a diminishing portion (less than 10 percent and declining) of the municipal bond market and, curbed by the Tax Reform Act of 1986, most of their damage has already been done.

At the very bottom of the default scale are tax-supported bonds (general obligations) and, especially, those sold for public education. Here again some sorting out needs to be done. Overall, tax- supported bonds had a tiny default rate of 0.4 percent for the period. Among general obligation bonds, 97 percent of the dollar volume in defaults ($1.12 billion out of $1.15 billion) was due to one borrower, California's Orange County. Only two other GO issues, amounting to $34 million, had payment interruptions. If we take out the Orange County hiccup (the county is investment grade now; it has fully repaid its debts), the GO bond default rate is utterly microscopic, on the order of .001 percent.

The rest of the "tax-supported" bonds that defaulted consisted of special assessment and special tax bonds. These were mainly land-based bond defaults in California and a sprinkling of other Western states that were hit by the real estate busts of the 1980s and early 1990s.

At the other end of the spectrum, state governments have had no defaults on their general obligations since the Great Depression. Even then, only the state of Arkansas temporarily pulled the plug. Perhaps the most amazing track record belongs to all those school districts that borrow: About 4,000 issue bonds each year and many appear as poor as church mice. But of the $300 billion or so in bonds sold for local school purposes from 1979 to 1997, total defaults (there were two) amounted to just $10 million, or a rate of 0.003 percent. No wonder that any school bond, whatever its rating and whether it's rated or not, is a prime investment.

The point of reeling off these statistics is twofold. First, state and local issuers may bask in the glory that no sector of the economy has the record for paying on time and in full as is found in the "traditional" municipal market. Second, even so, there are vast differences in tax-exempt securities, and those seeking risk can find it in the fringe of non-traditional uses. Health care continues to have its rough spots, and although the supply of industrial revenue bonds has been greatly curbed, they can still give a higher-risk, higher-reward ride for the truly greedy. But the true-blue municipal bond sold for traditional purposes is the gilt-edge security in today's bond markets. Enjoy!