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California city bankruptcies are raising questions about the municipal bond market

Federal Reserve Bank of New York

Last month, I wrote about Moody's, one of the big ratings agencies, and its view that the municipal bond market was getting a bit riskier than everyone has conventionally thought, in the aftermath of the bankruptcies of Stockton and San Bernardino and other U.S. cities. 

At the time, I noted that between 1970 and 2011, Moody's could find only one city — Cicero, New York — "electing to default on debt not out of ability to pay but willingness to pay."

What that implies is that the now $3.7-trillion muni bond market has been a safe investment for decades. As long as you're investing in rated bonds. (And even if you haven't, but more on that in a sec.)

Now the Federal Reserve Bank of New York has offered its own take, at its Liberty Street Economics blog. It differs from Moody's in terms of the looking at the entire muni market, not just the part that's rated by Moody's and others. The conclusion is represented in the graphic above. Moody's found 71 defaults between 1970 and 2011 — and that's total defaults in its rating universe, so presumably 70 we due to inability to pay while only Cicero strategically defaulted due to an unwillingness to pay.

The NY Fed found...2,521 defaults "in the same period."

Yikes! That's a big difference. But it can be explained. In two steps:

1. Bond issuers don't try to get rated if they don't think their bonds will, you know, rate!

2. Unrated bonds are far more likely to default than rated bonds. 

This is nothing new. In 2010, Municipal Bonds Today surveyed the muni market and counseled investors to avoid unrated bonds. Furthermore, while "71 defaults versus 2,521 defaults" makes the bond market look like less than a riskless investment, the larger number averages out to only 81 defaults on all muni bonds, rated and unrated, over a 31 year period. 

Looked at this way, this makes even unrated bond debt, with its accordingly higher rate of return, seem like a pretty tempting investment. And even, if you think about, an excellent high-return hedge against riskier investments in, say, stocks.

The upshot here that from Moody's to the New York Fed, the "riskless" muni market is being questioned. Bankruptcies in Stockton and San Bernardino have focused attention on the bonds that these cities have issued — as well as bonds issued by other cities in that could hit trouble in the future. That questioning is good. But it doesn't mean that the muni market is somehow vastly more unsafe than we've been led to believe.