Municipal Bonds and the Importance of Credit Quality

Overview: For many investors, fixed income (or bonds) is an important part of their investing equation. The following focuses on the quality of fixed income in light of recent headlines about municipal bonds.

In February, American Airlines parent company AMR Corp. asked a bankruptcy judge to permit AMR to stop payments on $1 billion of airport special facilities bonds for the Dallas-FortWorth International and Alliance Airport. American Airlines filed for bankruptcy in November 2011. It remains unclear what the recovery rate will be for investors holding these municipal bonds.

This story follows the failed prediction in December 2010 by financial analyst Meredith Whitney when she appeared on “60 Minutes” and forecasted there would be turmoil in the municipal bond market in 2011. Whitney went as far as predicting “hundreds of billions of dollars’ worth of defaults.” In a market that is approximately $3 trillion in size, 2011 saw approximately $2 billion of municipal bonds default, or just 0.07 percent of the total size of the market.

On their own, such news stories may cause investors to question the safety of fixed income. As the AMR case unfolds, it serves as a reminder that not all fixed income is equal in quality.

The Importance of Credit Quality
Because the overall goal of the fixed income portion of a portfolio is stability, the fixed income instruments chosen should be of the highest credit quality. The lower the credit quality of a bond, the more likely the issuer is to default. Obviously, the higher the likelihood of default, the less stability in the portfolio, which defeats the purpose of adding an allocation to fixed income in the first place.

In the case of municipal bonds, some bonds have been historically safer than others. For example, non-general obligation bonds such as health care and industrial development bonds have been historically much riskier than general obligation and essential services bonds.

There are several differences between general obligation and non-general obligation bonds within the municipal bond category. General obligation bonds typically fund capital improvement projects such as roads and schools. They are typically backed by the full faith and credit and taxing power of the issuer, which means the issuer can raise taxes to cover any principal and interest payment shortfall.

Non-general obligation bonds often are revenue bonds in which bondholders are repaid from revenue generated from sources such as leases and special taxes. The aforementioned AMR special facilities bonds are revenue bonds.

Moody’s conducts an annual study on municipal bond default rates and recoveries. According to the 2012 study, only 71 Moody’s-rated municipal issuers defaulted during the period 1970–2011. Of the 71 defaults, 66 were non-general obligation bonds with more than 70 percent from the housing and health care sectors.1 These statistics indicate that, historically, general obligation bonds and essential services bonds have defaulted much less frequently than non-essential services bonds.

Comparing Municipal Bonds With Corporate Bonds
When comparing municipal bonds with corporate bonds, a key difference is the recovery rates of bonds that default. Moody’s found that investors recovered 65 percent of their municipal bonds’ value when they defaulted (for the period 1970–2011), compared with 49 percent for corporate bonds (for the period 1987–2010).2 When Orange County, Calif., defaulted in 1994 (which is one of the largest municipal bond defaults in U.S. history), investors eventually received 100 percent of their principal and interest.

Ratings also mean different things across types of bonds. For example, a AAA-rated municipal bond is not the same as a AAA-rated corporate bond. According to Moody’s, for the period 1970–2011, municipal issuers had "lower average cumulative default rates than global corporate issuers overall, and by like-rating category."3 This should be considered when building bond portfolios.

Conclusion
For investors who do not want the risk of an all-equity portfolio, adding an allocation to fixed income helps dampen that risk. Thus, it is important to understand the proper way to incorporate fixed income instruments such as municipal bonds to give the portfolio the highest chance of success.

1 U.S. Municipal Bond Defaults and Recoveries, 1970–2011.Moody’s Investors Service, March 7, 2012.
2 Ibid.
3 Ibid.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2012, Buckingham Family of Financial Services.

 
 

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