The last couple of years have witnessed threatened or actual defaults in a diversity of places, ranging from Jefferson County, Alabama, to Harrisburg, Pennsylvania, to Stockton, California. But do these events point to a wave of future defaults by municipal borrowers? History—at least the history that most of us know—would seem to say no. But the municipal bond market is complex and defaults happen much more frequently than most casual observers are aware.Here's how they back up this view (my bold):
The $3.7 trillion U.S. municipal bond market is perhaps best known for its federal tax exemption on individuals and its low default rate relative to other fixed-income securities. These two features have resulted in household investors dominating the ranks of municipal bond holders. As shown below, individuals directly hold more than half, or $1.879 billion, of U.S. municipal debt; when $930 billion in mutual fund holdings is included, the household share rises to three-quarters. Although the low default history of municipal bonds has played a key role in luring investors to the market, frequently cited default rates published by the rating agencies do not tell the whole story about municipal bond defaults.
Two large bond rating agencies, Moody’s Investors Service (Moody’s) and Standard and Poor’s (S&P) provide annual default statistics for the municipal bonds that they rate. S&P reports that its rated municipal bonds defaulted only 47 times from 1986 to 2011. Similarly, Moody’s indicates that its rated municipal bonds defaulted only 71 times from 1970 to 2011. As shown in the table below, this record of defaults compares very favorably with the corporate bond market, especially given the larger number of issuers in the municipal bond market
However, not all municipal bonds are rated and the market’s rated universe only tells part of the story. We have developed a more comprehensive municipal default database by merging the default listings of three rating agencies (S&P, Moody’s, and Fitch) with unrated default listings as tracked by Mergent and S&P Capital IQ. Rather than confirming Moody’s 71 listed defaults from 1970 to 2011, our database shows 2,521 defaults during this same period. Similarly, our database indicates 2,366 defaults from 1986 to 2011 versus S&P’s 47 defaults during this same period. In total, we find 2,527 defaults from the period beginning in the late 1950s through 2011. (We don’t have complete information on the number of issues, so we can’t compare default rates.)
Our findings raise the question, What causes such markedly different default frequencies between rated and unrated municipal bonds? Our answer: Not all municipal bonds are created equal. Different types of municipal bonds are secured by very different revenue sources with varying levels of predictability and stability. Furthermore, we believe that rated municipal bonds tend to be self-selected: issuers are less likely to seek ratings if their municipal bonds are not likely to achieve investment grade ratings.
Given this analysis along with the earlier analysis by these economists that (my bold):
....there has been some recovery in the state sector, but we expect that the hangover from the recession will affect both state and local governments and the economy for years to come. Some of the actions taken to address short-term funding needs can increase the severity of the long-term structural challenges that states and localities face, including underfunded pension plans and deficient infrastructure stocks. Until these challenges are successfully resolved, the state and local public sector may continue to be a drag on economic activity in the years ahead.This is likely to be the closest you are going to get from the Federal Reserve itself that the municipal bond market is a minefield that investors stay away from. What's most intriguing is that these economists show the graph which displays that 75% of municipal bonds are held either directly or through muni bond funds by individuals. Could they be suggesting that if muni defaults pick up there could be a run out of the muni bond market? As far as I am concerned, reading between the lines, that is exactly what they are saying.