Municipal bonds are generally viewed as a relatively safe investment option during a recession. The default rate for municipal bonds from 1970 to 2019 was a mere 0.1%. Over the 2008 financial crisis, that default rate remained at only 0.02%. The low default rate has helped them become a reliable investment vehicle. Investors should consider credit ratings when investing in bonds and buy investment-grade bonds worldwide and across industries to lower risk as much as possible. Municipal bonds have a post-tax yield advantage for high-income investors because municipal bond interest is tax-free, giving them an important economic use during recessions.
Municipal Bonds’ Safety
Municipal bonds fall into two categories: general obligation bonds and revenue bonds. Since general obligation (GO) bonds are essentially supported by the full faith and credit of a government’s taxing power, they are generally considered safe investment instruments. Moody’s data showed that in 2009 the U.S. municipal bond default rate was only 0.03%, while corporate bonds had a default rate of 10.74%. Thus, they have a lower default rate than many other types of bonds, making municipal bonds one of the safest asset market investments when economies struggle.
From 1970 to 2019, the overall default rate among municipal bonds was only 0.1%, according to statistics from Moody’s, aligning with a significantly lower failure frequency than corporate bonds at this time. When the 2008 financial crisis came, municipal bonds carried only a default rate of about 0.02%, showing that they are stable during economic turbulence.
Some types of municipal bonds behave differently during economic recessions. Revenue bonds have more risk, as the repayment heavily depends on revenues generated from certain projects. A few tourism and hotel revenue bonds (0.5% default rate) defaulted under the broader array of bond types during the 2008 financial crisis, but general obligation bonds were less affected, with a default rate of less than 0.02%.
The Yield of Municipal Bonds
While municipal bonds generally yield lower interest rates, they are tax-free, which is attractive to investors. Interest income generated by municipal bonds is typically exempt from U.S. federal taxes and may also be exempt from state or local taxes, a factor that can make the effective interest rate on municipal bonds relatively high for some investors; however, these provisions do not apply to capital gains. For example, a municipal bond with an interest rate of 3% would be equivalent to a taxable bond yielding more than 4.62% for high-income investors in the 35% tax bracket.
In times of economic recession, market interest rates tend to fall, and the yields on municipal bonds reset lower too. Municipal bonds offer tax-free income, so while their average yield fell from 4.5% to 3.2%, the interest not being subject to federal and/or state taxes (often depending on where you reside) kept after-tax yields attractive based upon ex post performance during the Great Financial Crisis of 2008-2009.
The post-tax yield advantage of municipal bonds is even more substantial for high-income investors. If an investor is in the 37% tax bracket, a municipal bond priced to yield can provide as much cash five years from now as a corporate bond with a comparable yield. During times of economic recession, municipal bonds typically offer a yield advantage post-tax, making them more appealing.
The Safety of Municipal Bonds
Local government financial conditions can worsen during economic recessions, particularly in places that rely heavily on particular industries or economic bases. The risk of default in municipal bonds may be increased by lax fiscal management or political instability.
Certain areas that depend on tourism or emphasize certain types of manufacturing may see their economies wrecked. The 2008 financial crisis led to a drop in tourism across much of the developed world, which hurt yields and risk levels for municipal bonds based on revenues from hospitality services. Nevada suffered more than most, statistically showing an increase in unemployment from 4.7% to 14.0%, straining state and local budgets alike.
The government’s fiscal management capability is also a factor that affects the safety of municipal bonds. California had a massive fiscal shortfall in 2009 due to poor budgeting, and its municipal bonds saw their credit rating slashed. Effective fiscal management can ensure that resources are allocated reasonably by the government during economic recessions and that normal debt repayment is maintained.
Municipal Bond Risk Management
Investment in Diversity: Spread funds across different regions and bond types so that the default of one region or project has limited impact on the investment portfolio. For example, invest in a series of bonds that diversify your investment portfolio across educational, transportation, and healthcare sectors.
Look at Ratings: Credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch assign municipal bonds a credit rating that enables investors to gauge the type of risk associated with them. The overall municipal bond default rate is about 0.3%, according to Moody’s, but it is only a minuscule fraction of that for investment-grade municipal bonds (less than 0.1%) and almost ten times as high for non-investment-grade municipal bonds (more than 2%).
Examine the Fiscal Condition of Governments Involved: An issuer’s ability to repay its debts is a key consideration in investing in municipal bonds. Determine budgetary conditions by examining measures of local government shortfalls, fiscal excesses, or levels of indebtedness.
