Perspective on municipal bonds

Municipal bonds and mutual funds investing in them have been popular with individual investors for many years.  The principal attraction for most individuals is the federally tax-exempt income produced by these bonds, as well as the  possibility of similar state income tax treatment for bond holders residing in the issuing state.  Many market pundits have been cautioning that our on-going economic doldrums have caused a substantial  increase in the risk of these bonds as cities and states struggle with revenue shortfalls.

Clearly, these commentators have a valid point as defaults on municipal debt have been rising since the recession began.  Default totals were $8.2 billion in 2008 and $6.9 billion in 2009, both of which far exceeded the municipal bond default figure of $526 million in 2007.  Further, Richard Lehmann, publisher of the Distressed Debt Securities newsletter estimates the 2010 figure will be about $3 billion.

However, some additional statistics help to put these seemingly ominous figures in perspective.  Despite the elevated figure for 2009, the $6.9 billion of defaults represented only one quarter of one percent (0.25%) of outstanding municipal debt.  This represents quite a contrast to the 11% default rate on outstanding corporate debt that was logged  in 2009.

And,  even the the most financially challenged states have constitutional provisions requiring debt payments.  California’s constitution subordinates  bondholders only to their school system and Illinois ranks bondholders ahead of all other creditors.  Every state’s statutes will vary but the power to tax can serve as a powerful protection for most debt holders.