How Rare Are Municipal Bankruptcies? A Lot Rarer Than You Think

Author: USGI
Date Posted: November 3, 2015 Read time: 8 min

High-profile municipal bankruptcies are like commercial airline accidents. Both occur very infrequently, yet when they do occur, they tend to receive wide media attention.

Weighing in at $18 billion, Detroit's 2013 bankruptcy made fro some splashy headlines, but cases such as this are rare.

The odds of being struck by lightning are an insignificant 0.03 percent, yet many people still worry it might happen to them. There’s even a name for it: astraphobia. Similarly, some muni bond investors worry about municipal bankruptcies, based on recent high-profile cases, even though such cases occur very infrequently. 

Think Orange County, California, in 1994; Jefferson County, Alabama, in 2011; or Detroit, Michigan, in 2013, the largest in U.S. history. Today, federal legislators are debating whether to allow debt-strapped Puerto Rico, which owes around $70 billion, to file for bankruptcy, something even U.S. states are not permitted to do.

These cases can sometimes lead to splashy headlines, which contributes to the misperception that they happen much more often than they actually do.

What municipal bond investors need to know is that, though there’s risk involved with any investment, municipal defaults are rare, and significantly rarer than their corporate counterparts.

Between 1937, when the U.S. Bankruptcy Code went into effect, and 2008, approximately 600 municipalities out of 90,000 filed for Chapter 9 protection. Governing magazine estimates that between 2008 and 2012, “only one of every 1,668 eligible general-purpose local governments filed for bankruptcy protection.” That amounts to a barely-there 0.06 percent—nearly in line with the odds of being struck by lightning—and includes everything from Aaa-rated municipalities to junk.

So far this year, only three local governments have filed, a 75 percent decline compared to 2012.


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Often More Trouble than It’s Worth

One of the main reasons why municipal bankruptcies are so rare is because the hurdles are set exceedingly high. Unlike an individual or corporation, a city can’t independently arrive at the decision to file. Federal law allows local governments to file, but the municipality’s state government must also permit it. Strings ordinarily come attached.

Currently, only 12 states authorize municipalities to file for bankruptcy without conditions—Alabama, Arizona, Arkansas, Idaho, Minnesota, Missouri, Montana, Nebraska, Oklahoma, South Carolina, Texas and Washington State. Another 12 states permit filing only when certain conditions have been met.

U.S. States Have Different Approaches to Municipal Bankruptcy

There’s also a huge amount of pushback. Bankruptcy is never an easy decision, but for local governments, it’s often more trouble than it’s worth. Citizens oppose it since it often leads to painful budget cuts and austerity measures. Obviously bondholders and pensioners are against it. States don’t like it because they fear it might tarnish their reputation and lower their credit ratings. Following Detroit’s bankruptcy, borrowing costs in surrounding Michigan counties went up.

This could affect what a state contributes to the national economy. The diagram below, courtesy of HowMuch.net, shows the relative economic value of each state, with California (13.3 percent), Texas (9.5 percent) and New York (8.1 percent) generating the most.

Relative Economic Value of Each State

Highly-Rated Municipal Bonds Remained a Relatively Safe Asset Class

Closely related, default rates for high-quality municipal bonds—the kind our Near-Term Tax Free Fund (NEARX) heavily invests in—remain close to zero. Between 1970 and 2013, Baa-rated munis historically had similar default rates as Aaa-rated corporate bonds, according to ratings agency Moody’s.

Average Cumulative Default Rates, Municipals vs. Corporates: 1970-2013
10-Year Period
Ratings Corporate Municipal
Aaa 0.49% 0.00%
Aa 0.99% 0.01%
A 2.73% 0.05%
Baa 4.61% 0.32%
Ba 19.27% 3.53%
B 40.48% 15.14%
Caa-C 66.02% 14.64%

Out of 25,000 equity and bond funds, only 30 have managed to deliver 20 straight years of positive returns, according to Lipper. NEARX is one of those 30 funds.

That’s a rare achievement indeed and represents the kind of track record most investment firms envy.

The recipient of glowing acknowledgements by popular financial and investment newsletter writers, NEARX is also highly-rated by Morningstar. It holds five stars overall among 187 Municipal National Short-Term funds as of 9/30/2015, based on risk-adjusted return.

Start taking advantage of our fixed-income expertise by requesting more information on NEARX today.

 

TELL ME MORE ABOUT NEARX

 

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Past performance does not guarantee future results.

Total Annualized Returns as of 9/30/2015
Fund Year to Date Five-Year Ten-Year Gross Expense Ratio Expense Cap
Near-Term Tax Free Fund 1.59% 2.05% 3.03% 1.08% 0.45%

Expense ratio as stated in the most recent prospectus.The expense cap is a contractual limit through April 30, 2016, for the Near-Term Tax Free Fund, on total fund operating expenses (exclusive of acquired fund fees and expenses, extraordinary expenses, taxes, brokerage commissions and interest).Performance data quoted above is historical. Past performance is no guarantee of future results. Results reflect the reinvestment of dividends and other earnings. For a portion of periods, the fund had expense limitations, without which returns would have been lower. Current performance may be higher or lower than the performance data quoted. The principal value and investment return of an investment will fluctuate so that your shares, when redeemed, may be worth more or less than their original cost. Performance does not include the effect of any direct fees described in the fund’s prospectus which, if applicable, would lower your total returns. Performance quoted for periods of one year or less is cumulative and not annualized. Obtain performance data current to the most recent month-end at www.usfunds.com or 1-800-US-FUNDS.

Morningstar Rating

Overall/187
3-Year/187
5-Year/172
10-Year/120

Morningstar ratings based on risk-adjusted return and number of funds
Category: Municipal National Short-Term funds
Through: 9/30/2015

Morningstar Ratings are based on risk-adjusted return. The Morningstar Rating for a fund is derived from a weighted-average of the performance figures associated with its three-, five- and ten-year Morningstar Rating metrics. Past performance does not guarantee future results. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.)

Bond funds are subject to interest-rate risk; their value declines as interest rates rise. Though the Near-Term Tax Free Fund seeks minimal fluctuations in share price, it is subject to the risk that the credit quality of a portfolio holding could decline, as well as risk related to changes in the economic conditions of a state, region or issuer. These risks could cause the fund’s share price to decline. Tax-exempt income is federal income tax free. A portion of this income may be subject to state and local taxes and at times the alternative minimum tax. The Near-Term Tax Free Fund may invest up to 20% of its assets in securities that pay taxable interest. Income or fund distributions attributable to capital gains are usually subject to both state and federal income taxes.

A bond’s credit quality is determined by private independent rating agencies such as Standard & Poor’s, Moody’s and Fitch. Credit quality designations range from high (AAA to AA) to medium (A to BBB) to low (BB, B, CCC, CC to C).

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