Municipal Bond Default Frequency Is Far Greater Than Reported

Jason Appleson, Eric Parsons, and Andrew Haughwout

In our recent post on the state and local sector, we argued that structural problems in state and local budgets were exacerbated by the recession and would likely restrain the sector’s growth for years to come. The last couple of years have witnessed threatened or actual defaults in a diversity of places, ranging from Jefferson County, Alabama, to Harrisburg, Pennsylvania, to Stockton, California. But do these events point to a wave of future defaults by municipal borrowers? History—at least the history that most of us know—would seem to say no. But the municipal bond market is complex and defaults happen much more frequently than most casual observers are aware. This post describes the market and its risks.

The $3.7 trillion U.S. municipal bond market is perhaps best known for its federal tax exemption on individuals and its low default rate relative to other fixed-income securities. These two features have resulted in household investors dominating the ranks of municipal bond holders. As shown below, individuals directly hold more than half, or $1.879 billion, of U.S. municipal debt; when $930 billion in mutual fund holdings is included, the household share rises to three-quarters. Although the low default history of municipal bonds has played a key role in luring investors to the market, frequently cited default rates published by the rating agencies do not tell the whole story about municipal bond defaults.

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However, not all municipal bonds are rated and the market’s rated universe only tells part of the story. We have developed a more comprehensive municipal default database by merging the default listings of three rating agencies (S&P, Moody’s, and Fitch) with unrated default listings as tracked by Mergent and S&P Capital IQ. Rather than confirming Moody’s 71 listed defaults from 1970 to 2011, our database shows 2,521 defaults during this same period. Similarly, our database indicates 2,366 defaults from 1986 to 2011 versus S&P’s 47 defaults during this same period. In total, we find 2,527 defaults from the period beginning in the late 1950s through 2011. (We don’t have complete information on the number of issues, so we can’t compare default rates.)