Why is municipal-bond quality so high—and defaults so infrequent? We can find the answer by drilling into the tenets of fundamental analysis: understanding the quality and predictability of a bond’s cash flows and the attributes of bond issuers that make investors more confident that they can deliver.
Here’s a closer look at five reasons why muni defaults are rare:
1) Security: Muni Issuers Have the Power to Raise Taxes and Fees
The two principal types of municipal debt, general obligation (GO) and revenue, have traits that better equip them to deliver steady cash flows.
GO muni bonds are backstopped by the “full faith and credit” of the issuing government. Whether a GO funds schools, transportation infrastructure or other essentials, the issuer typically has the power to raise taxes to make bond payments. Many states and municipalities need voters’ approval even to issue GOs, and they can’t declare bankruptcy—even in a crisis. In the private sector, most companies can’t claim that type of customer backing or pricing flexibility.
Revenue bonds are backed by fees from public-service enterprises like utilities, toll roads and airports. Those fees are pledged to service debt, and in tough times, issuers can raise user fees to make debt payments. Most tax-exempt revenue bonds are at the top of an enterprise’s capital structure. Typical issues include safety provisions like requirements to set rates in excess of budgeted expenses, restrictions on issuing more debt, and requirements to fund reserves to cover unexpected events.
Compare a municipal-owned electric utility with one that’s privately owned. Given all the protections in the bond issue, publicly owned utilities can set their own rates. Privately owned utilities, on the other hand, need permission from an independent oversight regulatory commission.
2) Cash Flow: A Steady and Reliable Revenue Engine
Municipalities’ power to tax or charge for public services translates into a reliable revenue engine that yields dependable, quality cash flows.
Taxes, for example, are applied across a diverse base of earnings and property values. This creates a steady revenue stream for GO municipal issuers that’s very different from that of a corporate issuer dependent on discretionary spending. If one sector of the economy is hard hit in a recession, other sectors may be less so, allowing the core of the muni issuer’s revenue stream to stay relatively steady.
In the current downturn, muni credits are generally weaker, but default is still a distant risk, in our view. Tax revenues (income, sales and property) and user fees from essential services keep coming and remain diverse. That’s very different from the private sector; when airline usage shrivels or people stop buying cars, companies’ revenue streams dry up.
3) Reserve Funds: Flexibility to Navigate Economic Storms
In a recession, cash is king, and states today have record-level cash reserves—thanks to mandated reserves requirements. Both GO and revenue bonds benefit from an embedded culture and legal structure that favors robust reserve funds to weather downturns. As we described earlier, many revenue bonds include mandates for specific cash-reserve levels.
For GO bonds, it’s important to understand how municipalities handle their general fund budgets. States have a long history of building up reserves, especially when economies are strong. This has allowed them to successfully navigate challenging times such as the Great Recession and the COVID-19 pandemic without defaulting. Those budget balances have reached record levels today (Display).
