A small increase in the number of large municipality defaults over the last seven years has raised questions about how distressed municipalities may view and treat their various contractual obligations going forward. In response, some investors have increased their focus on the potential default risk found within the municipal bond market.
These investors may look to credit rating agencies, such as Standard and Poor’s (S&P) or Moody’s, who have conducted and published their own municipal default studies since 2008, for insight about distressed municipalities. These studies calculate the ratio of defaulted obligors in any given year versus the total obligors that the agency rates over the same time period. Using this method, default rates over any given period are extremely low — less than .01% overall.1
However, such reports only measure the rated obligors of each agency and tend to understate the municipal market’s true default rate, in our view. In reality, there are approximately 44,000 municipal issuers and hundreds of thousands of individual obligors found within the municipal market.2 Many of these issuers are non-rated and tend to be risker credits. This type of issuer would not be captured by the commonly used studies.
A better way to measure default rates, we believe, is to use the total par value defaulted within the market versus the total par value of the market. Strategy, research and advisory firm Municipal Market Advisors (MMA) uses this broad approach, and expands the definition of “default” to include various characteristics of distress. Using MMA’s calculation of total distressed par value, we estimate a higher overall default rate of approximately 1.6%.3 While this number is still very low, we believe it provides a more realistic view of the total distress found within the municipal market.
Implications for bond investors
In the foreseeable future, we may see rating agency default statistics rise, albeit only incrementally, as more economically distressed municipalities seek debt reduction through Chapter 9 bankruptcy. If the number of municipality defaults continues to increase, these types of obligors are likely to be found within a rating agency’s universe of securities and these events would eventually work their way into the various published default studies.
Currently, the Chapter 9 bankruptcy procedure is not authorized in all US states, but more politicians are beginning to view Chapter 9 as a tool that can provide debt relief for distressed municipalities. Factors such as an increase in the number of states authorizing Chapter 9 bankruptcy, published default rates incrementally rising or the more frequent occurrence of high profile municipality defaults may surprise some market participants. Negative investor reactions to these types of headlines could also lead to opportunity, in our view.
Our view and approach to municipal default risk
We believe negative, broad-brush reactions to the types of negative headlines mentioned above may result in some fundamentally sound credits being unfairly punished thereby providing attractive investment opportunities within the municipal bond market. We stand ready to capitalize on such opportunities if they arise.