Municipal bonds through a potential recession—What to expect

Key Highlights

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.

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.

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).

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).

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.

Notes:

• For more information about Vanguard funds and ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
• Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
• Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
• Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
• 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.