Why Widespread Muni Defaults Are Unlikely to Happen

The COVID-19 crisis opened up cracks in the muni market, but we don’t expect those cracks to alter the reality that municipal bonds can be a relatively conservative investment option. Many municipalities are under stress, but that’s not a reason to avoid munis, in our view.

COVID-19 has affected states to different degrees

States that are particularly dependent on the travel and leisure, energy, or service sectors have been “disproportionately affected by the pandemic” and “are generally seeing larger impacts on their economies and tax revenues” according to the National Association of State Budget Officers.1

A good illustration of the uneven impact that COVID-19 is having on states can be seen in their unemployment rates. State unemployment rates range from as low as 3.0% in Nebraska and South Dakota to as high as 9.3% in Hawaii which is closely followed by Nevada at 9.2%.

Moreover, some states are bringing in more tax revenues since the pandemic began relative to the same time last year as illustrated in the map below. States that have a higher dependency on sales taxes, as compared to income taxes, are experiencing greater financial pressures.

The COVID-19 crisis has had an uneven impact on state finances

Bankruptcy and default are different

When discussing municipal credit quality, we often hear the concern that municipalities will file for bankruptcy or may default on their bonds. Although often intertwined, a default and a bankruptcy are not the same.

A default is defined by Moody’s Investors Service as a missed interest or principal payment, an exchange where the bondholder received less than was originally promised, or a change in the payment terms. There are also “technical defaults,” where the issuer breaches a covenant, such as minimum debt service coverage, but the bondholder continues to be paid as usual.

A bankruptcy, on the other hand, is a legal process that provides a financially distressed municipality legal protections from creditors while it develops and negotiates a plan for adjusting its debts.

The distinction is important to bondholders because a municipality may default without filing for bankruptcy protection, or it may file for bankruptcy protection but continue to pay some bondholders.

Further complicating matters is that states can’t file for bankruptcy protection, and local governments in 23 states can’t either. The other 27 states that allow local governments to file for bankruptcy protection require the governments to overcome a series of legal hurdles first.