How Often Do Municipal Bonds Default?

Municipal bonds are debt securities issued by state and local governments, and their agencies, to finance public projects and operations. When an investor purchases a municipal bond, they lend money to the issuing entity. In return, the issuer promises regular interest payments and repayment of the principal at maturity.

Defining Municipal Bond Defaults

A municipal bond default occurs when an issuer fails to meet its obligations to bondholders. This can be a payment default, involving failure to make timely interest payments or repay principal, or a technical default, arising from a violation of bond covenants.

Municipal debt differs from corporate debt. Municipal bonds are backed by a government’s taxing authority or project revenue. General Obligation (GO) bonds are supported by the issuing government’s full faith and credit, often repaid through taxes. Revenue bonds are secured by income from the project they finance, such as tolls or utility fees.

If a revenue-generating project underperforms, it impacts the bond’s ability to pay, unlike GO bonds where the issuer can raise taxes. GO bonds generally have lower risk due to taxing power, while revenue bonds are more vulnerable to economic downturns affecting their specific revenue stream. Legal structures also vary, influencing default resolution.

Historical Default Performance

Historically, municipal bonds have demonstrated low default rates compared to other asset classes, such as corporate bonds. The 10-year cumulative default rate for investment-grade municipal bonds has been approximately 0.1% since 1970. In contrast, investment-grade corporate bonds experienced a 2.2% rate over the same period.

This trend highlights their relative safety, with some data showing a five-year municipal default rate as low as 0.08% since 1970. Reputable rating agencies like Moody’s and Standard & Poor’s consistently report these low figures, though some broader databases including unrated bonds may show higher numbers.

Even during economic stress, such as the 2008 Great Recession or the COVID-19 pandemic, municipal default rates have remained low. For example, in 2022, only one Moody’s-rated municipal issuer defaulted, demonstrating the sector’s resilience. This stability is often attributed to predictable tax revenues and the essential nature of the services they fund.

While defaults are rare, they occur. Certain subsectors, like housing or healthcare projects, have historically accounted for a larger share of rated default events. However, even within these sectors, default rates remain significantly lower than in the corporate bond market. The median rating for municipal issuers remains higher than for global corporates, reflecting their strong credit quality.

Reasons for Default

Several factors can contribute to a municipal bond default. Broad economic downturns can significantly affect local tax revenues, including property, sales, and income taxes, which fund general obligation bonds. When these revenues decline, a municipality’s ability to meet debt obligations can be strained, leading to fiscal distress and difficult choices.

Specific project failures are a common cause of default for revenue bonds. If the enterprise generating revenue, such as a toll road or utility, does not perform as expected, pledged revenues may be insufficient to cover debt service. Poor financial management or governance within an issuing municipality can also contribute to default. This includes inadequate budgeting, excessive borrowing, or a lack of transparent financial reporting, weakening an issuer’s fiscal health.

Significant demographic shifts, such as population outflow, can erode a municipality’s tax base, leading to sustained revenue declines and increased financial pressure.

Unforeseen natural disasters also pose a substantial risk. Events like hurricanes, floods, or wildfires can cause extensive damage, reducing property assessments and business activity, thereby decreasing tax revenues. While federal and state aid often mitigate some financial impacts, long-term strain from rebuilding efforts can severely impact a municipality’s ability to meet its financial obligations.

Investor Experience During Default

When a municipal bond defaults, it does not necessarily mean a complete loss of principal. The process often involves negotiations and restructuring to achieve some recovery. The bond trustee plays a central role, representing bondholders’ interests and ensuring compliance with the bond agreement. They monitor the issuer’s financial health and, in default, notify bondholders and initiate remedies.

Potential scenarios include debt restructuring, where bond terms like interest rates or maturity dates are modified to make payments manageable. This might involve delayed interest payments or a revised principal repayment schedule. Partial principal recovery is also possible, where investors receive a portion of their original investment back, often through a settlement.

In some cases, out-of-court restructurings are pursued, involving direct negotiations between the issuer and bondholders. If an out-of-court resolution is not feasible, a municipality might seek protection under Chapter 9 of the U.S. Bankruptcy Code. This process can bind all bondholders to a restructuring plan. While lengthy, recovery rates for defaulted municipal bonds have historically been higher than for corporate bonds.