Analyzing the quality of municipal bonds matters, especially if you’re concerned about default risk. General obligation (G.O.) bonds don’t default often, but defaults do happen. According to Moody’s, there were only 21 G.O. bond defaults from 1970 to 2016. Even though they’re rare, a few recent, high-profile examples include:
Corporate defaults often come down to a simple story: the company became less profitable, borrowed too much, or both. Municipal G.O. defaults are usually more complex. Because property (ad valorem) taxes are the primary source used to repay G.O. debt, analysts often focus on two broad drivers of credit quality: population and municipal finances.
Property owners in the municipality are the ones who ultimately repay G.O. debt through taxes. That means the characteristics of the city’s population can tell you a lot about the bond’s creditworthiness. Analysts typically watch:
Detroit is a useful example. One major contributor to Detroit’s default was its shrinking population. Detroit’s population has been in decline since 2001. When fewer people live in a city:
That chain of events increases default risk.
Income per capita is the average income of residents in the municipality. Higher incomes generally support stronger tax collections. If a large portion of residents can’t pay property taxes because incomes have fallen or jobs have been lost, the municipality’s finances can tighten quickly.
That’s why analysts watch collection ratios, which compare the amount of taxes assessed versus the amount actually collected. If the collection ratio starts to fall, it can signal that taxpayers are struggling to meet their obligations.
Economic diversity matters for the same reason. In the basics part of this chapter, we discussed how Detroit’s auto industry, which dominated its economy for decades, contributed to the default. A municipality with a diverse economy is usually better positioned to handle a downturn in any one industry.
For example, in 2018, WalletHub crowned Lawton, OK as the most economically diverse city in the nation. The city has employers across multiple industries, including education, food preparation, and health services. If one major industry weakened, other sectors could still support employment and tax collections.
Municipalities generally aim to maintain a healthy, balanced budget. Unlike the federal government, cities and states don’t have their own version of the Federal Reserve that can create currency during economic downturns.
When the national shutdowns in early 2020 from COVID-19 began, many cities and states showed signs of financial stress. As of April 2020, five issuers of $407 million in municipal debt skipped required interest or principal payments. If tax revenues dry up, municipalities need reserves and financial flexibility to keep making debt payments.
When you analyze a G.O. bond, municipal finances are a key part of the credit picture. For example:
Earlier in the issuance section of this chapter, we looked at the official statement for the Deschutes County education bond. Official statements include detailed information about an issuer’s financial condition. Highlights from the Deschutes County bond official statement include:
Several parts of an official statement include pieces of the municipality’s debt statement. Municipal debt is measured in different ways:
Direct debt
Net direct debt
Overlapping (coterminous) debt
Net overall (total) debt
In general, higher debt levels increase default risk. At the same time, not all debt creates the same burden, which is why these categories matter. For example, a municipality’s direct debt might look high, but it may be less concerning if much of it is self-supporting revenue bonds (bonds that generate revenue to pay themselves off and aren’t supported by taxes).
You don’t need to be an expert at interpreting official statements, but you should know what they contain and what they’re used for. Because G.O. bonds are repaid with property taxes, population demographics, economic diversity, and municipal finances are central to evaluating credit quality.
Sign up for free to take 6 quiz questions on this topic