Municipal Bond Defaults are Higher Than Reported

By Ron DeLeggeETFguide

The public has been showered with myths from economic decoupling to "risk free" rates of return on government debt, to outright lies that housing prices are incapable of declining more than 20%.

Among these fairyland views is the fanatical belief that massive municipal bond defaults aren't possible because default rates are historically low. How many times have we heard that baloney?

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A new study by the Federal Reserve Bank of New York debunks this claim. The study found that rating agencies are only counting defaults for the municipal bonds they rate, and as a result, they're providing a false picture of actual default rates in the muni bond market. (VIDEO: Is the $3.7 Trillion Muni Bond Market Too Big to Save?)

Moody's Investors Service (NYSE:MCO) and Standard and Poor's (NYSE:MHP) publish annual default statistics for the municipal bonds that they rate. S&P reports that its rated municipal bonds defaulted only 47 times from 1986 to 2011. Along similar lines, Moody's says that its rated municipal bonds defaulted only 71 times from 1970 to 2011.

Instead of agreeing with Moody's 71 listed defaults from 1970-2011, the Fed's database shows 2,521 defaults during this same period. Similarly, the Fed's data shows 2,366 defaults from 1986-2011 versus S&P's 47 defaults during this same period. In total, the Fed discovered 2,527 munibond defaults from the period beginning in the late 1950s through 2011.

Put another way, credit rating agencies are understating historical default rates in the municipal bond market (NYSEARCA:MUB) because they exclude unrated bonds, which paints an inaccurate view of actual credit risk.

Savvy investors like Warren Buffett understand the changing dynamics in the muni bond market and are bailing. Buffett's holding company, Berkshire Hathaway (NYSE:BRK-A), ended credit default swaps insuring $8.25 billion in muni bond debt.

The highest muni bond defaults are concentrated in community development projects, multi-family housing, and the industrial development sector.

Rather than heeding the warning signs, asset flows into troubled bond state specific funds like California (NYSEARCA:CMF) and New York (NYSEARCA:NYF) currently suggests investors are either complacent or ignorant. Through the first half of 2012, investors sunk a $31.56 billion in munibond funds. Not only does the existing pace easily beat last year's, but it's 40% more than the record inflows experienced during the first half of 2009-10!

The August issue of the ETF Profit Strategy Newsletter analyzes trends in the $3.7 trillion municipal bond market, identifying key inflection points that will radically alter this mega market. Yes there are warning signs, but there are also opportunities for astute investors.