How Safe Are Municipal Bonds?

Between November 2010 and the end of January 2011, municipal bond funds declined by an average of about 6%, although some declined by as much as 11%.

Declines in the price of municipal bonds (“munis”) are nothing new. Two significant declines occurred in 2008: the first in February 2008, and the second a virtual meltdown that took place as the financial panic of 2008 unfolded. Both declines were discussed in articles I wrote for the AAII Journal [past articles are available at AAII.com]. But one aspect of the most recent decline that distinguishes it from prior episodes is that it is generating heated and controversial discussions in the financial press and media. This is new. Unfortunately, much of this discussion is not well informed.

Much of the current discussion starts with a forecast made by Meredith Whitney, a highly regarded bank analyst, last December on “60 Minutes.” During that broadcast Whitney predicted that massive defaults were likely to occur in the municipal bond market. More specifically, she predicted 50 to 100 “sizeable defaults” generating “hundreds of billions of dollars” of losses. By now, that forecast has been repeated endlessly. Those who feel her forecast is justified cite two potential problem areas: first, general stress on the finances of issuers of municipal bonds such as states, counties and cities due to the continuing economic downturn; and, second, future problems due to significant unfunded liabilities for pension funds and the costs of healthcare to retirees.

A closer look at Whitney’s statement makes it very clear why knowledgeable analysts consider it to be highly exaggerated. Their objections center on the prediction of 50 to 100 “sizeable” defaults and the forecast of “hundreds of billions” of dollars of losses. Bear in mind that there are well over 55,000 municipal bond issues outstanding. In any given year, as many as 50 to 100 defaults do occur in the municipal bond market, although that number varies. But even if as many as 100 defaults do occur, say, within a year, that translates into a minuscule default rate: less than one-third of 1% of all outstanding municipal bonds. Moreover, these defaults tend to be concentrated among tiny issuers of bonds that fall into certain categories of municipals considered to be riskier: unrated bonds and those issued by private-purpose entities, such as nursing homes. Moreover, total aggregate amounts of defaulted bonds are in the range of $5 billion to $10 billion per year. So predicting hundreds of billions of dollars worth of defaults is either hype or a wild and careless exaggeration.

But while it is easy to dismiss this particular statement as hype, that does not mean that the road ahead for municipal bonds is without risks. Meredith Whitney’s prediction deals primarily with one risk—credit risk. But current buyers should be equally aware of two other types of risks. The first is the risk that prices will decline if interest rates rise—interest rate risk. The second, which has played an increasing role in all three of the recent declines in the municipal bond market, is “sell-off” risk—panic selling that creates a severe imbalance between buyers and sellers.

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