Download Municipal Bonds and the Importance of Credit Quality

March 2012
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-Fort Worth
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.
March 2012 - Municipal Bonds and the Importance of Credit Quality
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.
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U.S. Municipal Bond Defaults and Recoveries, 1970–2011. Moody’s Investors Service, March 7, 2012.
Ibid.
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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