Default rates by municipal bond issuers have been remarkably low over the years. It’s an impressive track record, and it explains why defaults by municipal issuers Puerto Rico and Detroit have made front-page news when they happen—they’re actually quite rare.
Since 1970, the 10-year cumulative default rate for investment-grade municipal bonds has been 0.1% (Display). Comparing muni default rates with those of investment-grade corporate bonds, which have defaulted at a rate of 2.3%, reinforces the reliability of municipal bonds.
Why is municipal-bond quality so high—and defaults so infrequent? We can find the answer by drilling into the tenets of fundamental analysis: understanding the quality and predictability of a bond’s cash flows and the attributes of bond issuers that make investors more confident that they can deliver.
Here’s a closer look at five reasons that muni defaults are rare:
1) Security: Muni Issuers Have the Power to Raise Taxes and Fees
The two principal types of municipal debt, general obligation (GO) and revenue, have traits that better equip them to deliver steady cash flows.
GO muni bonds are backstopped by the “full faith and credit” of the issuing government. Whether a GO funds schools, transportation infrastructure or other essentials, the issuer typically has the power to raise taxes to make bond payments. Many states and municipalities need voters’ approval even to issue GOs, and they can’t declare bankruptcy—even in a crisis. In the private sector, most companies can’t claim that type of customer backing or pricing flexibility.
Revenue bonds are backed by fees from public-service enterprises like utilities, toll roads and airports. Those fees are pledged to service debt, and in tough times, issuers can raise user fees to make debt payments. Most tax-exempt revenue bonds are at the top of an enterprise’s capital structure. Typical issues include safety provisions like requirements to set rates in excess of budgeted expenses, restrictions on issuing more debt and requirements to fund reserves to cover unexpected events.
Compare a municipal-owned electric utility with one that’s privately owned. Given all the protections in the bond issue, publicly owned utilities can set their own rates. Privately owned utilities, on the other hand, need permission from an independent oversight regulatory commission.