Measuring Municipal Default Risk.

• Author: Litvack, David
• Position: Statistical Data Included

The bond rating agency Fitch IRCA recently completed a study of municipal bond default risk. The study revealed that risk of default for municipal bonds is very low, but varies by market sector. This article is the result of that study.

Credit ratings are assigned to debt securities as an indicator of default probability. However, it is a common perception among investors that not all securities with the same rating have similar risk levels. For example, 'A' rated corporate bonds are perceived as having greater associated risk than 'A' rated municipal bonds. Even within municipals, perceptions of different risk levels exist (e.g., typical 'A' rated hospital revenue bonds are perceived as having greater risk than a typical county's 'A' rated GO bonds). Some variations in perceived risk can be explained by differing expectations of ultimate recovery if default occurs. However, the results of Fitch IBCA's municipal default study provide evidence that actual incidence rates of default differ. Municipal debt in general shows lower default rates than corporate bonds, and there is a wide range of default rates for various municipal sectors.

Methodology

Fitch IBGA first reviewed a number of existing publicly available studies which indicated greater frequency of defaults in sectors like industrial development bonds (IDBs), health care, and multifamily housing. To perform its own analysis, Fitch IBCA purchased a database of municipal debt payment defaults that have occurred since 1980 from Bond Investors Association (BIA). The database excludes purely technical defaults but includes insured or letter of credit (LOC)-backed debt where issuers defaulted and investors continued to receive payments from the credit enhancement provider.

Sorting this database by sector revealed similar findings of default frequency as the earlier studies. Fitch IBCA then grouped the defaulted debt by date of original issuance and compared it to new issue volume data for bonds and notes published in editions of The Bond Buyer! Securities Data Company Yearbook to calculate cumulative default rates by dollar volume and number of issues. Finally, Fitch IBCA analyzed default and issuance volume by sector to determine sector-specific default rates. Fitch IBCA calculated default rates by sector based only on dollar volume, not number of deals, since number of deals by sector is not available from The Bond Buyer! Securities Data Company Yearbook for issues under 13 months.

Distribution of Defaults

As indicated by Exhibit 1, most municipal defaults occurred in the industrial development sector, followed by multifamily housing and health care. There was also a large dollar volume of electric power defaults. However, most of these resulted from a single event--a court ruling in 1982 invalidating take-or-pay contracts that various municipalities entered into with the Washington Public Power Supply System (WPPSS), which caused the default of more than $2.2 billion of revenue bonds. Tax-supported debt also showed a relatively large volume of defaults. However, almost 60 percent of these were special assessment bonds covering relatively narrow tax bases, and another 30 percent were...