The muni opinion: Default risk or just catchy headlines?

The following is a commentary by Philip G. Condon, head of municipal bond portfolio management; Ashton Goodfield, head of municipal bond trading; Carol L. Flynn, head of municipal bond research; and Anthony Parish, Fixed-income product specialist, at DWS Investments, a member of Deutsche Bank Group. A few weeks ago a story flashed across our Bloomberg screens announcing “Municipal Bond Defaults Continue at Triple the Typical Rate…” We have grown accustomed to headlines such as this in recent months. They seem to be multiplying like weeds. They often have scary headlines that grab the reader's attention and suggest there's an epidemic of municipal bond defaults just about to hit. This one went on to say, “Thirty-five municipal bond issues totaling $1.5 billion defaulted in the first six months of 2010…” What the story didn't mention is that 35 bond issues worth $1.5 billion is a minuscule number within the muni market, which is vast. How vast? By some estimates, it consists of approximately 1.5 million CUSIPS (the unique identifiers given to each security traded in the United States), though some believe the number is closer to 2 million. The total muni market is valued at about $2.8 trillion. In dollar terms, $1.5 billion out of $2.8 trillion is a default rate of about five-hundredths of one percent. In our opinion, that rate really doesn't deserve such a sensationalist headline. What's worse, most of the news stories fail to distinguish the different types of bonds, such as investment-grade vs. non-investment-grade, different sectors, regions, etc. These distinctions are crucial for investors, since some types of bonds tend to encompass the majority of muni bond defaults.

LET'S DO AN INVENTORY OF DEFAULT STATISTICS

A default occurs when a bond issuer misses a payment that has been promised to bondholders. The default rates among investment-grade municipal bonds (in Moody's terminology, those rated Baa and higher) are published by many sources, including the rating agencies Moody's and S&P. According to Moody's, the 10-year average cumulative default rate among investment-grade munis has been 0.06%.1 This includes virtually no defaults among the highest-quality group (Aaa), and a 0.16% default rate among the lowest-quality category within this group (Baa). How does that compare to the default rate on investment-grade corporate bonds, for instance? Investment-grade corporates have a default rate of about 2.5% over the same time period. Looking at it another way, for every one high-quality muni bond that has historically defaulted, there have been about 41 defaults among high-quality corporate bonds.

'WHAT, ME WORRY?'

Some investors may believe that the chances of owning a muni bond that defaults is similar to the chance of getting struck by lightning—not statistically different from zero—and therefore disregard muni default risk altogether. That's a dangerous leap of faith for two reasons. First, as you notice from the stats above, the official default rates for non-investment-grade munis are much higher than the rates for investment-grade munis. Default rates jump from 0.16% to 2.80% to 12.40% for bonds rated Baa, Ba and B, respectively. That's an ominously steep curve. Second, these “official” numbers don't tell the whole story. Why is that? Because the rating agencies typically only include statistics on bonds they rate, so their statistics don't capture the bonds that are not rated. According to research by Municipal Market Advisors (MMA), two-thirds of the number of muni investments that were in default or had credit impairments by the end of June 2010 (376 out of 558) came to market without a credit rating. Even in dollar terms, more than a third of the troubled investments came to market without a credit rating ($8.3 billion out of the $23.8 billion). Looking at it another way, the industry default statistics published by the rating agencies fail to capture the part of the market that produces the biggest cluster of defaults. So, investors shouldn't get too smug about muni issuers rarely missing a payment to lenders, otherwise they may be underestimating the risk of default. How can investors navigate the uncertainty? Well, they can start by staying away from the riskiest sectors. According to MMA research, land-secured bonds account for 38% of the 558 investments that are currently impacted by notices of payment defaults and severe credit impairments. Municipal housing deals account for 11.6%; retirement facilities account for 10.8%; and industrial development deals account for 5.7%. Other risky sectors, including hotel, toll road/transit and tribal bonds, together account for another 25.3%. However, sticking with the so-called safe sectors doesn't guarantee immunity from problems, either. MMA says more than 8% of problematic investments (46 out of 558, or $8.2 billion) are associated with issuers of general obligation, water/sewer and sales-tax-backed bonds. With the current concerns about municipal budgets, investors should be very selective about choosing their investments. If you invest in any bond funds, go through the holdings listed in their annual reports. We are shocked by the number of impaired securities we see in some of the popular muni mutual funds. If you own individual bonds, you can now get their filings and other data on the EMMA web site maintained by the Municipal Securities Rulemaking Board. (You can get there by googling “emma muni”—even if you choose Google's “I'm Feeling Lucky” button.) Smaller municipal issuers and those with low debt-coverage ratios, narrow revenue base and/or meager reserves are likely to be most at risk.² We favor larger issuers that have more resources to get through the lean years and those that offer greater liquidity. Good credit research is more important than ever, as is broad diversification across sectors and geographies.³ If you are trying to choose which muni fund is right for you, we recommend you define your goals and acceptable risk levels. For instance, the risk/return characteristics of safe, short-to-intermediate-term funds are different from those of mid-quality, longer-term funds and different still from high-yield muni funds. Knowing which category best matches your profile can help make the choice easier. Above all, don't let the “data fog” paralyze you into not doing anything, and by all means don't treat all issuers and all sectors in the same way. If you do your homework, stay diversified and stick mainly to the safer issuers and sectors, you should be OK. However, if you think default risk isn't worth worrying about in the muni market, or you get greedy and reach for the highest-yielding investment, you could be surprised by the number of impaired credits you have in your portfolio. Above all, the message isn't, “Don't worry at all about the headlines.” The message is, “Most of the headlines shouldn't concern you if you are prudent.” ^{2 - The debt-coverage ratio compares the sum of a company's borrowings and the current portion of its debt to operating cash flow. 3 - Diversification neither assures a profit nor guarantees against a loss.}