By Joe Mysak
Jan. 12 (Bloomberg) -- Fewer stomachs churned in the U.S. municipal bond market last year.
In 2006, $1 billion in municipal bonds defaulted, down from $3 billion in 2005, according to the Distressed Debt Securities Newsletter, of Miami Lakes, Florida.
That $3 billion figure was triple the usual amount that we have seen default in recent years. Much of it was due to airlines defaulting on the tax-exempt debt they used to build facilities at airports. Most of those bonds remain in default.
The $1 billion figure is likely to increase a bit, says Jack Colombo, senior editor of the newsletter, which tracks both corporate and municipal bond defaults. The final figure is tweaked during the course of the following year.
By comparison, some $7.2 billion in corporate bonds defaulted in 2006. That was down from the $36 billion that blew up in 2005.
The record year for municipal bond defaults, for those counting, was 1991, when almost $5 billion went bust.
``Default'' doesn't necessarily mean that bondholders don't get paid. It is usually defined as what happens when issuers fail to send in enough money to their bond trustee to repay debt service. The trustee then taps reserve funds, which usually run out after a year or two.
No Link
There's no correlation between the amount of bonds that are sold in a given year and the amount of bonds that go into default. Defaults typically take a year or two or three to occur.
That $1 billion in defaults shows just how hard you have to look for trouble in the municipal market. There were $383 billion in municipal bonds sold last year, according to the Bond Buyer newspaper, making it the third-busiest year on record. By the time every last bond issue is reported, 2006 might even be the second-busiest year.
To put it all in perspective, there is something like $2.3 trillion in municipal bonds outstanding, and the Distressed Debt Securities newsletter says that there are a cumulative 1,378 unresolved defaults totaling $16.6 billion out there.
As I say, you have to really look for trouble. You can usually find it in the unrated, high coupon bonds sold for nursing homes, multifamily housing and industrial development.
Most municipal bonds don't default; the bonds sold by states and localities and backed by their taxing power, hardly ever. It makes you wonder why bond insurance is so popular.
Of the $383 billion in municipal bonds that were sold in 2006, almost half were insured. That's a pretty amazing statistic.
Sound Sleep
There are good reasons for it. Bond insurance is sleep insurance for nervous investors, who are willing to forego a little yield in exchange for extra safety. If an issuer defaults on its bonds, insurers such as MBIA, AMBAC, FSA and FGIC make sure they get paid.
In practical terms, this is even rarer than actual occurrences of default, because the insurers tend not to underwrite junky bonds.
I suspect the real reason bond insurance is so popular with issuers, however, is because it serves as credit enhancement. When an issuer gets a bond insured, the bond gets the insurer's triple-A rating.
This can mean some pretty big savings. A BBB-rated bond issuer pays 4.28 percent to borrow money for 10 years. The same issuer pays 3.89 percent if he gets his bonds insured, which means they then carry an AAA rating. On a $1 million bond, that translates to a savings of almost $40,000 over the life of the bond, more than enough to cover the cost of the insurance.
Cure Rate
It takes a long time to cure a bond default. Consider the Four Corners, California, Public Financing Authority. In November 1997, the authority sold $19.8 million in revenue bonds to finance certain improvements to the Jensen Ranch and Riverbend Ranch Public Golf Course and Residential Communities in Madera County, California.
The unrated bonds were underwritten by Pacific Genesis Group, and for some people, like specialists in the California municipal market and a raft of unhappy investors, that's all you would have to say. The firm was shut down by regulators in 2001 after underwriting almost $250 million in bonds designed to finance real-estate developments. The bonds all subsequently went into default.
The Four Corners bonds defaulted in 1999. They were found taxable by the Internal Revenue Service in 2003. Next Wednesday, Jan. 17, the property securing the bonds -- and three other series of bonds -- is going to be auctioned, after which the bondholders will, at last, get something.
That's a scary story, all right, and it's not that unusual. On Jan. 9, the U.S. Bank National Association made what is termed a ``final distribution'' to owners of some defaulted Wasco, California, Public Financing Authority bonds sold to build a golf course. Like I said, it takes a long time to cure a default: the bonds, sold in 1989, defaulted in 1994.
(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)
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