Have you heard the old trope about the municipal bond market being as exciting as watching paint dry?
Turns out it’s true.
Municipal bonds are for the faint of heart. Generations have regarded them as a relatively safe and dependable source of tax-free income. While high-profile events in the last decade or so punctuated headlines and chatter among pundits, they obscured the much larger picture, as illustrated by a 48-year muni market study by Moody’s, the ratings agency.
The upshot? The image of a staid but reliable market is largely true. Defaults are exceedingly rare, and issuers have mostly rebounded since the Great Recession. Further, it’s important for investors to understand what they’re buying.
In other words, the market is essentially what successful, long-time municipal bond investors know it to be.
Muni market study shows upswing in muni bond market
The public finance sectors, Moody’s said, “has been notable for infrequent defaults and extraordinary stability throughout the study period (1970-2017).”
“Overall, the municipal sector is now stable, if not improving, nearly a decade after the Great Recession (2007-2009),” Moody’s said in its report, “U.S. Municipal Bond Defaults and Recoveries, 1970-2017.”
Upgrades continue to outnumber downgrades, while “credit quality for general governments and municipal utilities has now rebounded,” the agency said.
For 2018, the ratings agency expects defaults “to be fewer and much smaller in magnitude” than last year.
Bond ratings matter
The muni market study also reiterated the importance of ratings to investors. As Moody’s noted, “Municipal ratings successfully differentiate defaulters from non-defaulters.”
The company said defaulters in 2017 were on average rated below 99.3% of the rated municipal universe as of January 1, 2017. Over a five-year period (2013-2017), municipal defaulters were on average rated below 91.3% of the rated municipal universe as of January 1, 2013.
Further, it’s critical for investors to understand each issue’s unique characteristics.
“An important observation from our 48-year study period is that any one default may only reflect the idiosyncrasies of an individual credit, and not be symptomatic of any general sector trend,” Moody’s said.
Municipal bonds vs. corporates
Another point the muni market study underscores is the “essential” difference between corporate and municipal credits. Moody’s showed “municipal credits had lower or equal average cumulative default rates across all horizons and rating categories over the entire study period compared to global corporates.”
Indeed, municipal default rates were a scant .09% since 1970, while the global corporate default rate was 6.7%.
While noting the infrequency of defaults and “extraordinary stability” of the public finance sector, Moody’s also noted changes in the market brought on by issues such as pension exposure, demographic shifts and exposure to the asset markets.
What investors should know
The Great Recession and challenges facing Puerto Rico have been sobering reminders that it’s imperative for investors to understand the bonds they’re buying and match them with their investment objectives.
They must also avoid getting derailed by headlines, a lesson reinforced by the study and well-understood by veteran investors, who get their excitement from generating a reliable stream of tax-free income.