VIA Times – January 2015 Issue Vital News, Vibrant VIews for Asian Americans in Chicago & Midwest
By: Jan Pau C. Ferrer
Assessing Credit Risk in the Current Environment
The ongoing financial struggles of several major cities capture continued media attention. But these problems were the result of individual circumstances and should not be construed as indicative of the overall health of the municipal market, which many market participants believe remains strong.
The City of Detroit may have dominated municipal finance headlines for more than a year with its long descent into bankruptcy and its contentious reorganization efforts since. But a closer look suggests that there may be little in these select events that apply to the overall state of municipal bonds.
For example, it is true that there was an increase in municipal bond defaults in 2013, to seven from six in 2012 among the municipal bond issuers rated by Moody’s. But four of those seven defaults involved entities connected to Detroit (such as schools) who were dragged down by the city’s primary insolvency.
1 There have been 30 defaults since the recession began in early 2008. This averages five defaults per year compared with an average of 1.3 annual defaults over the period 1970 2007. 1 To put the default numbers in perspective, although the bond amounts involved in the high-profile defaults may look large when viewed in isolation, they account for a very small percentage of the overall municipal bond market, which tallied some $3.7 trillion at the end of 2013, according to the Securities Industry and Financial Markets Association (SIFMA), an industry trade group.
2 In other words, the great bulk of municipal bond debt is being repaid on time.
After holding periods of 10 years, the average cumulative default rate for investment-grade municipal bonds rated by Moody’s was 0.08%, ranging from 0.01% for Aa-rated debt to 0.32% for Baarated debt. There were no defaults of Aaa-rated municipal debt during the study period.
Source: Moody’s, US Municipal Bond Defaults and Recoveries, 1970-2013, May 7, 2014.
A Closer Look at the Municipal Market
There are two broad categories of bonds in the municipal market:
• General obligation bonds are the direct debts of a state or local government entity and are backed by the issuer’s full faith and credit. Historically, general obligation bonds issued by states have shown a negligible default risk. A small number of cities and towns have defaulted on general obligation debt over the years, but bondholder losses have been relatively small in comparison to the overall market, and recovery values have tended to be higher than for revenue bonds.
• Revenue bonds are bonds tied to a particular project or agency. Since revenue may come from a specified tax, a particular user fee or toll, or a lease payment. Revenue bonds tied to commercial projects may carry additional risks if a tenant in the project becomes bankrupt.
Many other factors impact the risk and reward potential of any specific municipal bond. Among them are the availability of collateral or insurance to secure repayment and the health of the economic environment for the bond issuer. These factors are usually reflected in credit ratings. They may also be reflected in the prices of bonds relative to others in the market.
Let me work with you and help you assess the value of a specific bond for your investment needs and risk profile.
As with all fixed income securities, interest rate risk is a consideration, especially as our forecast is calling for a rising interest rate environment.
Footnotes/Disclaimers 1Moody’s, US Municipal Bond Defaults and Recoveries, 1970- 2013, May 7, 2014.
2SIFMA market estimate is as of December 31, 2013, published on July 7, 2014, and retrieved from http://www.sifma.org/research/statistics. aspx on July 7, 2014.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer.
Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one’s state of residence and, if applicable, local tax-exemption applies if securities are issued within one’s city of residence. The tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability. The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value.
Insurance for bonds is subject to the claims paying ability of the insurer.
If you’d like to learn more, please contact Jan Paul Ferrer.
Article by Wealth Management Systems, Inc. and provided courtesy of Morgan Stanley Financial Advisor.
The author(s) are not employees of Morgan Stanley Smith Barney LLC (“Morgan Stanley”). The opinions expressed by the authors are solely their own and do not necessarily reflect those of Morgan Stanley. The information and data in the article or publication has been obtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of Morgan Stanley. Neither the information provided nor any opinion expressed constitutes a solicitation by Morgan Stanley with respect to the purchase or sale of any security, investment, strategy or product that may be mentioned.
Morgan Stanley Financial Advisor(s) engaged Via Times to feature this article.
[Jan Paul Ferrer may only transact business in states where he is registered or excluded or exempted from registration [http://www.morganstanleyfa.com/ferrer. Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Jan Paul Ferrer is not registered or excluded or exempt from registration.
