Last week the New York Fed put out a controversial report claiming that the default rate for municipal bonds is 36 times higher than one cited by credit rating agencies. Using data sets from S&P Capital IQ and Mergent that tracked defaults for unrated bonds, the New York Fed report created a big stir among muniland commentators and probably a small amount of concern among retail investors. The data cited by the New York Fed is well known among market professionals and has been thoroughly dissected, but so far the discussion hasn’t focused on why these unrated bonds default at higher rates. Specifically, no one has linked the high default likelihood of this sector, private activity bonds, to the fact that Congress has exempted them from rigorous disclosure since 1968.
Randall Forsyth at Barron’s pulled the right information from JPMorgan municipal bond research to explain what this unrated sector of high defaulting bonds is. Take special note of that last section:
“The vast majority of defaults came from revenue bonds, which are backed by the cash flows from a specific authority or entity, such as a municipal hospital, or an industrial-revenue bond issued on behalf of a private entity. In other words, by far the diciest niche of the muni market.
Indeed, defaults were concentrated in a relatively small, high-risk subsector of the muni market, according to data collected by Priscilla C. Hancock, managing director at J.P. Morgan Asset Management. Moreover, the data also show that even in default, bondholders recover a substantial percentage of their investment.
In recent years, the defaults in the muni market have been centered in just a few areas, according to J.P. Morgan’s numbers. From 2000 to 2011, corporate-related bonds, such as industrial-revenue bonds, accounted for 34 percent of defaults. Within that sector, American Airlines’ bankruptcy was responsible for a whopping 84 percent of those defaults. The AMR unit was responsible for debt for airport facilities; but that is representative of a corporate-credit risk, not that of municipalities.