HJ Sims

Where are the Potential “Hot Spots” for Municipal Credit Risk in 2012?

Municipal credit risk will continue to be concentrated in the high-yield sectors of corporate industrial revenue bonds, development district (sometimes called utility district) bonds, the housing bond sector, and the healthcare/nursing home sector. I still believe that total tax-exempt defaults will not exceed $20 billion this year.

The foundation for my forecast comes from a study of municipal bond defaults that occurred between 1979 & 1986, a period of the highest measured credit risk since the Great Depression, performed by Fitch Ratings in 1999. The period of 1979-1986 was marked by some extraordinary economic circumstances that, while different from the root causes of the current recession, still represent one of the most difficult economic periods in post-World War II history, as shown by these events:

• The period was marked by not one, but two recessions between 1979-1982 (6 months in early 1980, and 1 year four months from mid-1981 through late 1982);
• A major energy crisis in 1979 after the Iranian Revolution, which drove up energy costs dramatically for the second time after the original 1973 Energy Crisis;
• A period marked by high-double digit inflation rates, as well as record-high interest rates in the early 1980’s (when the prime interest rate rose as high as 20.0%, resulting in the highest municipal borrowing costs in history);
• Mushrooming tax-exempt debt by conduit bond issuers trying to take advantage of expiring tax-exempt regulations in 1986’s Tax reform Act; and
• The largest single municipal revenue bond default, totaling billions of dollars, by the Washington Public Power Supply System (WPPSS) in 1982.

The most interesting feature of Fitch’s 1999 Default Study was that it included all tax-exempt bond issuance, not just those that were rated by the major rating agencies. It also delineated defaults by type of issuance and purpose so that conclusions could be reached on defaults by sector, rather than a one-size-fits-all default rate. This feature of the tax-exempt bond market is well-known by municipal bond professionals, which explains why there is a high-yield sector for municipal bond trading that differs greatly from the majority of tax-exempt debt that is issued by city, state and local governments across the United States.

The bulk of municipal bond issuance is for General Purpose, Education, Water and Sewer Utility service, Transportation, Public Facilities, Environmental Projects, and municipal Electric Power, mostly represented by state, city and school district agencies that enjoy taxing power, and/or virtually monopoly control on tax/revenue raising, rate setting and expenditure levels. These sectors had among the lowest average annual rates of default during this period. These sectors (which I call the Governmental and Utility Sectors) also issued 83% of all debt issued ($2.9 trillion out of $3.5 trillion) as measured over the last ten years by the Daily Bond Buyer, the municipal bond newspaper which tracks tax-exempt bond issuance and municipal credit news.

The high-yield sectors include Development bonds, which are made up by industrial revenue bonds that are backed only by corporation guarantees, and development district bonds commonly known as “dirt” bonds. The housing sector and healthcare/nursing home sectors are traditionally also viewed as high yield sectors. These three areas, which only account for about 17% of all debt issued in the last 10 years, could account for 85% of projected defaults in 2012.  The yields in these sectors are attractive in the current environment of record low interest rates, if the investor is selective. While we offer full-spectrum investing, HJ Sims specializes in fixed income bonds, including high yield, non-investment grade tax-free issues that have been uniquely crafted or reviewed by our experts in the senior living, health care and education sectors. Through the years, we’ve compiled an impressive track record:

• Since 1965, we’ve issued over $7.5 billion in high yield, non-investment grade bonds
• Of these, over $3.8 billion have already reached maturity, been repaid or closed
• The composite return on these issues translates to an average modified yield of 9.66%.

In order to arrive at $20 billion dollars of municipal bond defaults for the next 12 months, using the 1979-1986 period as a guide, you would need to increase those annual average worst-period default rates during that period to nearly SIX TIMES that average:

• Development bonds could default at a one-year rate of about 10%, for an estimated total of $7 billion dollars of defaults out of about $72 billion outstanding;
• HealthCare (Hospital and Senior Living bonds) could default at about a 2% rate, or $7 billion out of an estimated $351 billion outstanding;
• Housing bonds are estimated to default at about a 1 ½% rate, or about $3 billion of an estimated $200 billion outstanding; and
• Governmental and Utility sector bonds might total $3.0 billion of defaults in 2012, or a one-year default rate of 0.1% (a little more than one tenth of a percent of the $3.5 trillion of debt issued in these sectors over the last 10 years).
• Finally, $20 billion of total defaults (which is my worst case estimate) pales in comparison to $3.5 trillion of outstanding bonds, and would still amount to less than 1% of all outstanding municipal debt.

For more detail and analysis, please email Dick Larkin for the full Sims report, “Municipal Bond Credit Outlook: The ‘Real Dope’ on Where Defaults can be Anticipated in 2012”.