Muni Flaws: Should Investors Be Worried?
By Michael Cohick
Senior Product Manager
Despite rating changes and volatility in the municipal bond market for 2021, Moody’s annual report offers an overall picture of stability. We explore the main results.
At the end of April, Moody’s Investors Service published its annual municipal bond market overview.U.S. municipal bond defaults and recoveries, 1970-2021, with updates through 2021. In addition to noting that the muni sector has continued to recover from the effects of COVID-19, the report also affirms two characteristic advantages offered by muni bonds. First, while they may have become more frequent over the past 15 years, defaults and municipal bankruptcies remain rare overall. (Indeed, there were no new defaults of rated municipal bonds during the period of significant market stress in 2021 resulting from COVID.) Second, municipal bonds continue, on average, to be well rated by relation to businesses. However, while they may have leveled off in 2021, according to Moody’s, cumulative default rates have been rising since 2010.
Again, an important observation noted in this year’s report was that over the 52-year study period: “Any default may reflect only the idiosyncrasies of that individual credit and may not represent a trend industry general.
Regarding the effects of the pandemic, Moody’s notes that in addition to the acceleration of remote learning and working and the associated estrangement from high-density employment and living, there is not only public health impacts but also “potential longer-term effects for K-12, higher education, and the transit sector…” All of this is worth watching in the context of the municipal bond market.
Muni Bond defaults and bankruptcies are more common, but still rare
The report draws attention, once again, to the fundamental difference between municipal loans and business loans.
Even though the five-year average municipal default rate since 2012 is 0.1%, compared to 0.08% over the entire study period (1970-2021), it remains extremely low. This is especially true when compared to the five-year default rate of 7.2% in 2012 and 6.8% in 1970 for global companies.
Vis-à-vis Puerto Rico, Moody’s notes in its report that “several other Puerto Rican credits that initially defaulted in 2015-17 began to recover in March 2022.” And that “the history of Commonwealth debt litigation and recoveries … is broadly reminiscent of the power of credit fundamentals, such as leverage, operational balance and economic capacity, over ostensible security features written on paper. While legal certainty will influence the recovery, credit fundamentals are driving defaults. »
This year’s report notes “the continued absence of rated defaults due to natural disasters” as an “interesting trend”. Although the small town of Paradise, California was nearly destroyed, it continued to pay its obligations. Moody’s describes this as demonstrating that “the will to repay debt can overcome many obstacles, including, in this case, small-scale, near-total destruction.”
Continued stability for municipal bonds
In 2021, there were more rating changes and rating volatility than in previous years, but relative to that of global corporate bonds, it was “significantly lower” as the US public sector showed resilience. a “great resilience in 2021”. (Credits benefited from a combination of direct federal and market support, active debt management, and “strong reserves through 2020.”) And indeed, even with the continued effects of the pandemic, there have been more municipal bond upgrades than downgrades.
According to the report, municipal credits generally remain very strong and “their rating distribution is significantly skewed towards investment grade, where ratings tend to be more stable.”
The report adds that the municipal sector as a whole remains highly rated with approximately 91% of all municipal credits rated by Moody’s falling in the A category or above at the end of 2021, similar to 2020. Additionally, at the end of 2021, the median US municipal credit rating remained at Aa3 (2020: Aa3). This continued to contrast sharply with the median rating for global companies, which was, once again, at Baa3 (2020: Baa3).
Muni Bond Market demonstrates strength and resilience
While we continue to argue that municipal bonds still provide a fiscally sound vehicle for generating a revenue stream free of federal and certain state taxes, it remains difficult to obtain the same level of timely disclosure from issuers than that observed in other asset classes. Despite this, the behavior of the muni market during the COVID crisis in 2020 and 2021 is At first glance proof of both its “solidity” (and its common obligations) and its resilience.
According to Moody’s report, there were only 114 separate defaults rated by Moody’s, amounting to just over $72 billion, across the universe of more than 50,000 state, local issuing authorities. and other different between 1970 and 2021. There remain, as always, caveats. As Moody’s puts it: “The once-comfortable aphorism that ‘ammunition does not fail’ is no longer credible: rating volatility, rating transition rates and cumulative default rates (CDRs) have all increased since 2010, although they have stabilized through 2021.” However, even when under virus and post-virus stresses, they have remained surprisingly stable so far.
Challenges facing this sector continue to be changing demographics (aging and relocated populations – affecting tax revenues), “substantial increases in the leverage of pensions and health care in retirement” and “the increased exposures associated with equity markets”. In addition to these, it remains to be seen what the full effects will be of the new dynamics that have become and are becoming all too apparent with the arrival and devastation wrought by and the continued recovery of COVID.
Despite this, we still believe municipal bonds remain important to the core strategy of building an individual portfolio.
Learn more about VanEck’s municipal bond ETF suite.
Originally published by VanEck on July 27, 2022.
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Source: Moody’s Investors Service: Defaults and Recoveries of U.S. Municipal Bonds, 1970-2020.
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