Vanguard believes inflation will come down in 2023 but at the cost of recession across several major markets. Recessions typically lead to credit downgrades in municipal bonds, and we believe 2023 will be no different.

In our view, the municipal bond market is broadly in strong shape and investors should remember 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.

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 the numbers reach 5% or higher.

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

In the rare instances when municipal defaults involving large dollar amounts do occur, they 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 worse scenario than is warranted. 

Whether it was financial analyst Meredith Whitney’s 2010 warning about a state pension crisis or the apprehension that followed the bankruptcies in Detroit and Puerto Rico, the municipal market has periodically been roiled by predictions of doom 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: 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.

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 attributable 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% of 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 most 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 report 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. (A basis point is one-hundredth of a percentage point.) 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.

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 >>

• Investor pulse: Less market pessimism, more economic optimism (article, issued January 26, 2023)
• Munis bounce back with high yields, strong fundamentals (article, issued October 6, 2022)