Monday, December 13, 2010

Bond Girl: Default and bankruptcy in the municipal bond market

by Calculated Risk on 12/13/2010 12:36:00 PM

There have been quite a few bearish articles recently about the muni market. Not long ago there were even some "scary charts" showing a sharp sell off for the muni market, and at that time Bond Girl pointed out the correction was not because of imminent muni defaults, but because of the end of the Build America Bond (BAB) program.

For those who want to know more about munis, here is an ubernerd post from Bond Girl at Self-evident.org: Default and bankruptcy in the municipal bond market (part one)

I am just writing this post to demystify a process that evidently needs demystifying. ...

One of the more frustrating aspects of muni market coverage in the news and blogosphere is the tendency to talk about municipal debt as if only one type of bond is issued and traded. There is actually considerable diversity among borrowers in the muni market (e.g., they are not all government entities), and by extension, the types of commitments that are made for the repayment of the debt. Although the relative health of the muni market has macroeconomic consequences, this is in many ways a market that defies generalization. (That’s one reason I find the muni market unusually interesting ...) The defaults that have taken place both before and during the economic downturn are what finance-types would refer to as storied credits. I often see people describing Jefferson County, Alabama, as the “canary in the coal mine” of muni defaults. Suggesting that Jefferson County, which was the center of a widely-publicized securities fraud case, is a typical muni credit is kind of like portraying Enron as a typical corporate credit. ... Another example would be Florida dirt bonds, which are backed by special assessments on property in a severely depressed market. These are not borrowers that were forced to establish their spending priorities or were muddling through difficult times; these are borrowers that experienced sudden and catastrophic losses and derived their revenues from limited sources.

Types of municipal bonds

The obvious starting place on this topic is to explain the types of muni bonds that are issued. Municipal bonds are broadly divided into two classes: general obligation (GO) and revenue bonds. The difference between GO and revenue bonds is the specific security that is pledged to repay the debt. (Bonds may also be issued with more than one kind of security and may involve a moral obligation pledge that implies contingent financial support from another entity with stronger credit.) GO bonds are secured by the full faith and credit of the issuer, meaning that the borrower is committing to raise taxes and other revenues sufficient to cover the amount owed.

Revenue bonds are secured by a defined stream of revenues. Whether the principal and interest on these bonds is paid in a timely manner depends upon: (1) the reliability of the specific revenues pledged; and (2) whether that revenue stream has been pledged toward other debt or is used for other purposes.

It is important that you understand what kind of bond you have. ...
There is much more on munis at the post.