Municipal bonds through a potential recession what to expect

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Municipal bonds through a potential recession—What to expect

Vanguard Perspective


January 10, 2023

Key Highlights

The economy is expected to enter a recession next year, which typically leads to credit downgrades in municipal bonds. We believe 2023 will be no different, which may spark headlines that raise concerns for the tax-exempt market.

While waves of downgrades can occur in difficult economic times, defaults are rare, and state and local finances currently are in the best shape they have been in for more than 20 years. Cumulative defaults over the previous 10 years total less than 0.1% of the municipal investment-grade1 market, according to Moody's data as of December 31, 2021.

Portfolios with well diversified holdings provide investors comfort that the occasional default will not materially impact the fund.

Vanguard currently believes a recession will likely arrive this year, and municipal bond investors should expect that headlines about the potential for downgrades and defaults will soon follow.

We would like to proactively reassure you that the municipal bond market is broadly in strong shape, and remind you that there is a huge difference between a downgrade by a credit agency and a default that requires sacrifice by bondholders.

Even if there are pockets of credit stress, the benefits of diversified bond funds can greatly temper portfolio impact. And as active managers, we have already positioned our portfolios with our market expectations in view.

Downgrades happen regularly

Let's consider how municipal bonds have historically performed through economic cycles.

Downgrades occur in municipal bonds as they do in other fixed income credit sectors. In any given year, roughly 1% of AAAs, AAs, and As each are downgraded a full rung according to Moody's data from 1970 to 2021.

Notably, these are lower rates than what occurs within the global corporate market, where such data figures are 5% and higher.

Downgrades may become more numerous in recessions, although typically with a lagged effect.


One-year drift and volatility ratios of U.S. municipal issues, 1970–2021

One-year drift and volatility ratios of U.S. municipal issues, 1970–2021 chart

Source: Moody's Investors Service, as of December 31, 2021.

In times of economic decline, downgrades are the rule while municipal defaults remain rare events. Looking at a history of defaults, these tend to be quite low year-to-year. Even in years with large dollar amounts of defaults, these events tend to be limited to a single issuer and represent the end of a long, slow decline attributable to localized economic stress, failed projects, or general mismanagement.


Default amount by sector per calendar year

Default amount by sector per calendar year chart

Source: Moody's Investors Service, as of December 31, 2021.

Nonetheless, when there is a noteworthy credit event in municipal bonds, some commentators, as they have in the past, may forecast a worst-case scenario than is warranted.

Whether it was financial analyst Meredith Whitney's 2010 warning about the pension crisis, or the apprehension that followed the bankruptcies in Detroit and Puerto Rico, the municipal market has been roiled at times by predictions of doomsayers that never came to pass.

Currently, however, we see that states' rainy-day reserves are flush, pension contributions are broadly increasing, and state and local tax collections have been very strong for two years in the aftermath of the pandemic.

The main takeaway is: municipal bond downgrades are a common occurrence during recessionary times. Defaults attract a lot of attention, but they tend to be more the result of idiosyncratic circumstances and/or events.

How rare are municipal bond defaults?

Cumulative default rates for investment-grade municipal bonds total 0.09% over ten-year periods, on average. This compares with 2.17% for the global corporate market—well over twenty times that of municipals according to Moody's data as of December 31, 2021.

A large part of this difference is due to higher credit ratings in the municipal market: BBB rated bonds, the lowest rung on the investment-grade ladder, represent nearly 50% of investment corporate bonds but just over 6% for the municipal market. There are structural reasons for that: states, cities, and local issuers of tax-backed bonds can draw on reserves, increase taxes, cut spending, or pull other levers to pay off their debt.

Even within high-yield tax-exempt bonds, where the vast majority of municipal defaults occur (See first graph below), we see that defaults are far less common for municipal debt than corporate bonds (See second graph below).


U.S. municipals ratings one year prior to default, 1970–2021

U.S. municipals ratings one year prior to default, 1970–2021 chart

Source: Moody's Investors Service, as of December 31, 2021.

Trailing twelve-month speculative-grade default rates


Trailing twelve-month speculative-grade default rates chart

Source: Moody's Investors Service, as of January 1, 2021.

Investors who access the tax-exempt bond market through diversified mutual funds and ETFs benefit from an additional layer of safeguarding. That's because a single credit event, or even a few, will have limited impact upon the larger portfolio (most funds will provide their total number of holdings on their website).

Using the number of holdings and an assumed 52% recovery rate (source: Moody's©), we can calculate an "average" portfolio impact in basis points if a random credit in the portfolio defaults. For example, the impact of a single default in a fund that holds hundreds or thousands of bonds would be limited to a few basis points (bps).


Defaults have far less impact on larger portfolios

(Impact of a single default, based on a 52% recover rate)

Defaults have far less impact on larger portfolios chart

Source: Vanguard calculations based on Moody's© Investors Service.

We hope this summary highlights the high-quality profile of the broad municipal bond universe, differentiates the nature and frequencies of municipal downgrades versus defaults, and underscores the benefits of a diversified portfolio.

Learn more about Vanguard’s municipal bond product line-up.

1 A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.


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  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

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