A default is a situation when a debt obligation is not met, that is, the principal or interest payments are not paid when they are due. Not all bonds are subject to default risks. Any security issued directly by the federal government, such as Treasury securities and savings bonds, are considered free from risks of default, even though they are unrated. These are considered risk-free because a default by the federal government is considered all but impossible.
The frequency of defaults depends on the type of bonds. Municipal bonds are considered the second safest category following securities issued by the federal government.
Within municipal bonds, general obligation bonds are considered the safest, since they are backed by the full faith, credit and taxing powers of the government that issued the bonds. Some jurisdictions may be in better financial shape than others. There are also fewer risks during economic upswings when governments usually collect more revenues from taxes.
Revenue bonds are considered riskier than general obligation bonds because repayment is dependent on specific revenue streams, such as user fees or lease payments. Revenue bonds issued for private institutions such as hospitals are even more risky. If the institution goes bankrupt and is unable to meet its debt obligations, the government or agency issuing the bonds for the companies is not under any legal obligation to repay the debt.
Though municipal bonds are considered safe, as in any other any investment, they have some risks. The two major risks include:
Credit risk - This occurs when a government entity issues bonds and then runs into economic and/or political problems, making its unable to pay the interest or return the principal. Bondholders can protect against credit risks to a large extent by checking the credit rating of a bond issue and/or making sure that the bond is insured.
Interest risk - Since bonds are fixed-income investments, municipal bond prices are inversely related to interest rates. Individual investors can't really do much about interest rate risks other than be aware of the fact and decide on his/her threshold for rate changes.
In the event of a default, bondholders seldom lose all of their principal value of the bond. Often, a default could result in the suspension of the coupon payment. Defaulted bonds can become speculative as they can be purchased fairly cheaply. If the issuer files for bankruptcy but reemerges successfully, then anyone who purchased the bonds when the company was in default stands to gain from the transaction.
TRENDS IN MUNICIPAL DEFAULTS
In 1988, a study by Enhance Reinsurance Co. looked at historical patterns of municipal defaults from the 1800s to the 1980s and concluded that municipal defaults usually follow downswings in business cycles and are also more likely to occur in high growth areas that borrow heavily.1 Following the 1873 Depression, when more than 24 percent of the outstanding municipal debt was in default, the greatest number of defaults occurred in the South, the fastest-growing region at the time. Factors that caused defaults included fluctuating regional land values, commodity booms and busts, cost overruns and financial mismanagement, unrealistic projections of the future, and private-purpose borrowing. The report also said that since World War II, revenue bonds have been a new source of default, largely a result of revenue overprojections.
The most infamous default cases involving general obligation bonds include New York City's default in 1975 and Cleveland in 1978. The largest default in the history of the municipal bond market was the Washington Public Power Supply System's (WPPSS) default on $2.25 billion in bonds. WPPSS launched a risky program to build five nuclear power plants in the 1970s to supply electricity to the Pacific Northwest. Only one of the five planned nuclear plants was ever completed. The WPPSS fiasco gave a lot more credibility to concerns that tax-exempt bonds were not a completely safe bet.
In 1999 Fitch Ratings published its first study of municipal defaults, which was updated in 2003.2 The latter study covered 2,339 cases of municipal defaults worth $32.8 billion between 1980 and 2002. It found that the cumulative default rate on bonds issued through 1986 (as they approached or reached maturity) was 1.5 percent, while the cumulative default rate on bonds issued between 1987 and 1994 was 0.63 percent. Municipal bonds issued on behalf of corporations or by municipal entities had a much higher overall default rate because of their exposure to corporate risks such as bankruptcy.
Cumulative default rates were found to be lower for bonds issued after 1986. Fitch attributed this to the Tax Reform Act of 1986 (which restricted the issuance of tax-exempt debt, particularly poor performing industrial development bonds), better disclosure, better financial management practices by issuers, greater scrutiny by different stakeholders, and improved economic conditions, including lower interest rates, which lowered the cost of borrowing.
Default rates, however, varied significantly across municipal sub-sectors, even though the overall rate was low compared to many fixed-income sectors. The study found that the 16 to 23 year cumulative default rates for tax-backed and traditional revenue bonds were less than 0.25 percent. Industrial revenue bonds had a cumulative default rate of 14.62 percent, multi-family housing 5.72 percent, and non-hospital related healthcare 17.03 percent. These three sectors accounted for 8 percent of all bonds issued but 56 percent of defaults. Education and general-purpose sector bonds accounted for 46 percent of issuance but only 13 percent of defaults.
One of the new findings in the 2003 study was that there was a moderate correlation of default risk with economic cycles, though a one-year lag produced a higher correlation. During the early 1980s and the early 1990s when economic growth was slow, default rates were the highest.
Another new finding was that defaulted municipal bonds have a fairly high recovery rate of 68.33 percent based on the number of defaults. Recovery can be made in a couple of ways. The borrower may get out of the default situation by making full debt service payments or collateral securing the bonds may be liquidated. Most issuers, particularly providers of essential services such as water and sewer, resume paying debt service. These types of securities are backed by physical assets that are public property. Thus they are never pledged to bondholders. In such cases, bondholders maintain a lien on revenues, which often enables full recovery. Industrial development bonds and multifamily housing bonds, the two sectors with the highest default rates, are often backed by collateral leading to higher than average recovery rates.
In the early 1990s, Standard & Poor's warned that the number of ratings downgrade could increase as a result of the increasing number of local governments that were considering not making lease payments on their outstanding certificates of participation (see the Financing Prisons section for an explanation of these certificates). The new trend was arising out of conditions faced by most local governments across the nation at the time. Many small issuers had entered the leasing market in the mid-1980s and governments began to test their abilities to make lease payments from operating revenues as those projects were just coming into use in the early 1990s. Faced with difficult fiscal situations and less than anticipated revenues from projects financed with bonds, many municipalities began to question whether they should continue to make lease payments on their outstanding debt. Standard & Poor's, however, stated that it expected most small and large issuers to honor their lease payments, if only out of fear of being downgraded or losing access to the facilities being leased. A downgrade usually means higher interest rates, which in the long run can make borrowing prohibitively expensive.
DEFAULT AND CREDIT RATINGS
Investors rely on credit ratings, which indicate the probability of default. A high credit rating indicates a low probability of default and vice versa. Both municipal bonds and corporate bonds are rated by rating agencies that specialize in evaluating credit quality.
The 1999 Fitch study of municipal debt defaults was followed by a revision of its rating criteria for many sectors of public finance. The study concluded that management practices were more important for predicting credit performance than had been thought in the past. The three most important management practices identified that led to stronger credit and lower defaults were:
- Superior disclosure
- Maintaining rainy day funds or operating reserves
- Implementing debt affordability reviews and policies
REVENUE BOND DEFAULTS AND THEIR IMPACT ON GOVERNMENTS
The River Square Parking Garage (Spokane, WA)
In 1998, the Spokane Downtown Foundation, a non-profit corporation, sold $31.5 million in revenue bonds to finance a parking garage for the River Park Square Mall backed by the moral (i.e., non-binding) obligation of the City of Spokane. A lease between the Foundation and the Spokane Parking Public Development Authority backed payments for the bonds. The city also pledged to contribute parking meter revenues for the operation and maintenance of the garage. A contract between the developer of the mall and Nordstrom, the mall's major tenant, allowed the retailer to choose the garage operator, set parking rates and approve any changes to the contract.
The Foundation defaulted on its debt payment after revenues from the garage fell short of projections. Bondholders argued that the city had pledged to back the revenue bonds with parking meter revenues. But the city reasoned that it could not honor its pledge to loan money to the authority since it was improbable that it would be repaid and thus would be illegal under the city's investment guidelines. The bonds went into technical default in 2001 and monetary default in 2003, resulting in a downgrade of the city's bond rating. In 2001 Moody's downgraded the city's unlimited tax and general-obligation bonds from A1 to A2, the city's limited tax general obligation bonds from A2 to A3, and the city's water and sewer revenue bonds from A1 to A3. Standard & Poor's downgraded the city to BBB and the parking garage bonds from BBB- to D (junk status) and switched to Not Rated in September 2003.3
Institutional and retail investors sued the city, the developer of the garage and the underwriting team. The city of Spokane sued its bond counsel Perkins Coie and its chairman and partner Roy J. Koegen, saying that that the law firm should become liable if the city became liable. Perkins Coie terminated its relationship with the city as outside bond counsel in 2001 and closed its Spokane office in 2002.
In mid-April 2004, Spokane's chief financial officer announced that the city would arrange for interim financing to settle the lawsuit by selling six-month bond anticipation notes. The Spokane City Council approved selling up to $39 million in long-term, limited tax general obligation bonds to raise money for settling the lawsuit in early April. The city's purchase of the garage from the Foundation was deemed taxable by the Internal Revenue Service in a preliminary ruling in 2001. That ruling is still being negotiated because the Foundation disputed the agency's findings. A lawyer representing institutional investors said that the city would indemnify bondholders if the IRS ruling held.
While the city was raising the money to settle the lawsuit, it also planned to get money from other defendants named in the lawsuit, which included underwriter Prudential Securities (now a part of Wachovia Securities) and the bond counsel Preston Gates & Ellis. Walker Parking Consultants, Inc., the firm that had provided the estimates for the garage was also a defendant in the lawsuit.4 It agreed to pay the city $1.5 million. Including expenses such as attorney fees and unpaid interest payments, the $31.5 million bond issue was expected to cost the city $34.0 million.5
In mid-April, the presiding judge postponed the scheduled trial in federal court after bondholders agreed to settle with the city, arguing that the case would possibly never go to trial if the city settled with all the parties involved. If the case does go to trial, the city would become the litigant against any remaining defendants.
The Cicero Commons Recreation Facilities (Cicero, NY)
In 2001, the Cicero Local Development Corp. (CLDC) sold $15.25 million in revenue bonds to help finance the $16.5 million Cicero Commons Recreation Facility that included two skating rinks and a YMCA on 140 acres of land. The town of Cicero signed a 41-year lease with the Corporation and also backed its general obligation debt and underlying mortgage. But the Facility failed to generate adequate revenues to cover debt service payments. Bank of New York, the trustee, made debt service payments by drawing on reserves, which led to a technical default by the Corporation in August 2003. Moody's put the Corporation and Cicero's credit rating under review following the technical default.
In November 2003, Cicero defaulted on its monthly interest payment of $513,000 and had only $236,000 in reserves. The Cicero Town Council had a line item in its 2003 budget for the Facility but did not appropriate any money for the project until after the default.6
Between September and December, the Corporation's rating fell from investment grade to junk status (from Baa2 to Caa1) following three downgrades by the rating agency. The town was downgraded twice and fell to below investment grade rating (from A3 to Ba2).
Moody's also said that, "Future rating action will reflect the town's ability and willingness to honor their obligations as per the lease agreement, thus ensuring bondholder security as well as the ability of the CLDC to provide for debt service, and the rebuilding of debt service reserve, from its own resources."7
Wilkes-Barre, PA
When Wilkes-Barre, a small city of about 50,000 in eastern Pennsylvania defaulted on its debt service payment in 2002 on $5.3 million of taxable guaranteed revenue bonds, the bond insurer, Ambac Assurance Corp., was obliged to cover the missed payment. In December 2002, after announcing that Ambac had paid the claim, the company's managing director of public finance surveillance commented that it was an extremely rare occurrence as public finance was typically a safe bet and cities were typically a safe investment. Wilkes-Barre cured the default within four days after the bond payment was made by the insurer.
The Wilkes-Barre Redevelopment Authority issued the bonds in 1998 to finance construction and related work of an 80,000 square foot office building and rehabilitation of a parking garage. Both Moody's and Standard & Poor's assigned the insured debt a triple-A rating. The city's chief of administration said that the city had failed to make its payment on time because it had not received lease payments from its tenant. The bonds were secured by the full faith, credit and taxing power of the city's general obligation. In addition to the projected lease revenues the city was also collecting revenues from a tax increment financing district. The redevelopment authority took legal action against the tenant.
In this case, the default occurred because of the bankruptcy of the intended payer (the tenant) and the inability of the City to honor its pledge in a timely manner.8
DEFAULT: WHO'S ACCOUNTABLE?As the cases described in this section illustrate, there is no clean formula that determines who is accountable and who will bear the financial burden in case of a default. The outcome depends on circ*mstances and usually involves a litany of lawsuits. If payment is not resumed or covered by bond insurance, investors are, in some cases, able to recover their money through litigation, which can involve the entire range of actors, from the issuer to the bond counsel to the underwriters. What seems to be true is that, in most cases, none of the parties assume responsibility and are quick to blame someone else in the chain.
Notes
1. Cited in Bishakha Datta, "1st Study of Municipal Defaults Since 1970s TermsHigh-Growth Areas Most Vulnerable," The Bond Buyer, October 11, 1988.
2. David T. Litvack and Mike McDermott, Special Report: Municipal Default Risk Revisited, Fitch Ratings, June 23, 2003.
3. Rochelle Williams, "Moody's Hit Spokane with Downgrade, City Also Receives Negative Outlook," The Bond Buyer, August 8, 2001 and Nicholas Chesla, "Spokane Case Could be Settled," The Bond Buyer, March 31, 2004.
4. Rochelle Williams, "Consultant Misled Us, Lawsuit Charges Conflict of Interest," The Bond Buyer, July 24, 2000.
5. Michael McDonald and Rich Saskal, "Spokane, Wash., Looks at Bans to Cover Garage Debt Default," The Bond Buyer, April 19, 2004.
6. Michael McDonald, "Moody's Keeps Eye on Cicero, N.Y., LDC Debt, Despite Council Appropriations," The Bond Buyer, December 2, 2003.
7. Michael McDonald, "Moody's Places Cicero, N.Y., and its LDC on Watch for Downgrade," The Bond Buyer, September 2, 2003.
8. Aaron Smith, "Ambac Pays Claim after Wilkes-Barre Authority Defaults on Debt Payment," The Bond Buyer, December 20, 2002.
