CDFA Spotlight:
Default Risks of Conduit Bonds

By Stan Provus

Preview

Municipal bonds have consistently lower default rates and higher recovery rates than similarly rated corporate bonds. This article is intended to inform readers about these rates for different categories of municipal bonds so conduit bond issuers can acquire a better sense of the likelihood of conduit IDB or other bonds defaulting. In addition, we examine what happens when conduit bonds default.

Default and Recovery Risks By Municipal Sector

The data in this section is taken from a January 7, 2007 report by Fitch Ratings entitled “ Default Risk and Recovery Rates on U.S. Municipal Bonds”. The data is based on two comprehensive default studies on muni bonds conducted by Fitch in 1999 and 2003, which included all bonds that defaulted, not just those rated by Fitch. The studies covered defaults between 1987 and 2002.

Fitch concluded that the many subsectors of municipal bonds fit broadly into three categories. The lowest risk class consisting of GO and most appropriation-backed bonds of state and local governments, as well as GO and revenue bonds issued by long-standing essential purpose enterprises that have monopolies in their service areas like water and sewer authorities and public higher education institutions. According to Fitch’s default studies, from 1987-2002, the five to fifteen year cumulative default rates for this lowest risk class of municipal bonds was 0.24%, which was less than the 10-year cumulative default rate of 0.43% for AAA-rated global corporate bonds.

The second risk category of bonds consists of enterprises that serve essential governmental functions but are not fully insulated from competition such as hospitals, private higher education, and state multifamily housing. The five to fifteen year cumulative default rates for this second risk class of municipal bonds averaged about 0.70%, which was less than the 10-year cumulative default rate of 0.76% for AA-rated corporate bonds.

The third risk class consists of enterprises that must compete with private sector entities or securities with volatile revenue streams. These include Industrial Revenue Bonds, nursing homes and continuing care retirement communities, among others. The five to fifteen year cumulative default rates for this third risk class of municipal bonds averaged 3.65%, which was less than the 10-year cumulative default rate of 3.97% for BBB+-rated corporate bonds.

Clearly, there is a significant increase in risk from the second class of bonds to the third (421%), which includes IDBs. However, it should still be recognized that even though a bond may fall in the lowest risk category it still maybe a higher risk than a bond in the lowest default risk category, since ratings may be all over the place in any given category. For example, a BBB rated GO bond may have a higher default risk than a local multifamily housing project in an area with limited affordable housing.

In addition, Fitch concluded that below-investment grade and nonrated municipal bonds are approximately 10 times more likely to default than investment grade municipal bonds. We are, however, only reporting defaults here not losses, which is considered next under recovery data.

Recovery Data

Although there are very few muni bond defaults, recovery data indicates that losses are less than corporate bonds, which have an average recovery rate of about 40%. Typically, even when GO or essential government monopolies default, the entity generally recovers and pays debt service. In other cases, bondholders are able to get recoveries from the value of assets and in still other cases the bonds may be credit enhanced. Insured bonds account for about 50% of annual municipal bond volume (annual volume in recent years has been about $350 to nearly $400 billion a year). There are, however, cases where bondholders lose considerable money, like the WPPSS bonds, which defaulted in 1982, recovering less than 25%.

Fitch Recovery studies group recovery rates in six broad sectors. These six categories and their expected recovery rates are:

State GO and sales tax backed debt—100% of par recovery rates;
Local government GO and tax-backed bonds--100% of par recovery rates;
State and local leases and COPs plus airports and public power distribution revenue bonds—100% of par recovery rates;
The fourth class includes bonds backed by nursing homes, continuing care retirement communities, private higher education, and multifamily housing, among others—90% of par recovery rates;
The fifth and sixth classes include more specialized bonds with lower expected asset resale values. Recovery class 5 includes military housing and start-up toll roads--—70% of par recovery rates; and
The sixth class includes hospitals, private prison, stadium, student housing, and tribal gaming bonds—40% of par recovery rates.

What Happens When a Conduit Bond Defaults?

When a municipal bond defaults, the bond trustee will take charge of all matters. The essential reason for the presence of a trustee in any public financing is the protection of the bond owners. The trustee is responsible for enforcing many of the important promises the issuing authority and the obligor make to the bond owners. Regardless of the other interests the trustee may represent in the bond financing (including its own) any action the trustee takes or does not take must not be to the detriment of the bond owners. This is true prior to an event of default even though the trustee customarily takes direction from another party to the financing and often acts to protect the interests of the issuing authority. Following the occurrence of a default, the trustee's role becomes much more proactive and may often be at odds with the best interests of other financing parties.

When a bond issue defaults, the Trustee has a fiduciary obligation to act as a "prudent man " as if it were a bondholder. While the Indenture states that the Trustee can take remedies (accelerate the debt, seize and sell collateral, bring suit against parties, etc), it usually looks to the holders for direction and indemnity in this regard before taking any action. The Trustee always engages counsel at the expense of the Issuer/Borrower. If they refuse to pay or they have filed for bankruptcy, we ask the holders to pay our fees and expenses. If they refuse, we have the right under the indenture to take our fees/expenses out of any recovery in the bankruptcy.

Defaults can be broadly classified into three basic types. These are:

Credit (LOC) or bond insurance enhanced
Institutionally Held, and
Public, widely held

In cases where the declaration of default is directed by a letter of credit bank, the trustee will simply draw on the letter of credit and pay off the bond owners, leaving the letter of credit bank and its customer to work out their problems. If the issue is covered by bond insurance, the insurance company will take over the issue and begin making payments on the bonds directly. However, in situations where there is no alternative source of payment for the bonds other than the obligor and the project, in most cases the bond documents will require the trustee to take appropriate action to enforce the remedies provided in the documents for the benefit of the bond owners.

If the bond is held by an institutional investor(s), the trustee will generally take direction from the holder(s) and quite often leave the representation to the institution's counsel who may or may not also represent the trustee.

In a widely held bond Issue (public sale) the trustee must hire counsel and represent the holders until the issue is settled. The trustee follows the proceedings through bankruptcy court or liquidation process and pays the holders with any recovery based on their holdings. The trustee is indemnified by the holders and has a priority lien on the recovery and distribution as far as their fees and expenses are concerned. Unless the issuer has created a situation where they are liable, they typically do not incur any expense or have much of a role during the workout process although they generally stay abreast of what is happening. They will have to sign off on the final disposition of the case. This process can get very complex, so we have just provided a very broad overview.

Conclusion

Although conduit bond default rates are relatively low, an issuer should recognize that when you issue conduit bonds you are in the risk management business. An issuer must make informed decisions about proposed issues in terms of the likelihood and magnitude of conduit issue risks and the probability of paying substantial IRS fines or legal fees that in may not be reimbursed by conduit borrowers.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.

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