Fitch Provides Municipal Default and Recovery Expectations by Sector.
Fitch has concluded that various sub-sectors of municipal debt fit broadly into three classifications of default risk. The lowest risk class consists of general obligation (GO), tax-backed, and most appropriation-backed debt of state and local governments, as well as GO and revenue bonds issued by long-standing, essential purpose enterprises that are either natural monopolies or have strong protections against competition, such as water and sewer systems, public power distribution utilities, public higher education, and single-family housing revenue bonds. Since the Great Depression, there have been extremely few defaults in these sub-sectors. According to Fitch's default studies, from 1987-2002, the five- to 15-year cumulative default rates within these combined sectors averaged 0.24%, which was less than the 10-year cumulative default rate of 0.43% for 'AAA' rated global corporate bonds.
The second risk class consists of enterprises that serve essential purposes but are not fully insulated from competition or fluctuations in demand; sectors in this category include hospitals, private higher educational institutions, military, and state multifamily housing, airports, seaports, and toll roads with established traffic patterns. Defaults in this risk class have occurred occasionally but with far less frequency than other fixed-income securities. The five- to 15-year cumulative default rates within these sectors averaged approximately 0.70% versus the 10-year cumulative default rate of 0.76% for 'AA' rated corporate bonds. The third risk class includes enterprises that must compete against private sector entities or securities with volatile revenue streams. These include industrial development bonds, local multifamily housing, nursing homes and continuing care retirement communities (CCRCs), toll roads, and other transportation facilities that lack established traffic patterns, tobacco securitizations, and tribal gaming bonds. These sectors have default risk characteristics similar to corporations, and their five- to 15-year cumulative default rate averaged 3.65% versus the 10-year cumulative default rate of 3.97% for 'BBB+' rated corporate securities.
Fitch believes that these differences in default risk have only been partially incorporated into Fitch's current public finance ratings. In other words, Fitch believes an 'A' rated GO bond will have a lower default risk than an 'A' rated airport, which will have a lower default risk than an 'A' rated corporate or industrial development bond. Nevertheless, Fitch believes that within each of the three classes, ratings accurately represent default risk relativity (i.e. 'A' rated class 2 bonds will default with less frequency than 'BBB' rated class 2 bonds). Fitch adjusts the assumed default rates in Matrix to compensate for this disparity in default risk among the class 1, 2, and 3 bonds. The model uses the assumption that bonds in class 1 will default at a rate similar to corporate bonds rated one full category higher (i.e. a class 1 municipal bond rated 'A+' is assumed to default at the same rate as an 'AA+' rated corporate bond). Class 2 municipal bonds are assumed to default at a rate determined by the midpoint between the corporate default rate of the assigned rating and the rating one category higher. Class 3 bonds are assumed to default at the same rate as corporate bonds.
Because of the dearth of municipal bond defaults, recovery data are far from robust. However, available data demonstrate that most municipal sectors have superior recovery prospects to corporate bonds, which have an average recovery rate of about 40%. Fitch considers the recovery prospects of municipal bonds as fitting broadly into six classes. State GO and tax-backed debt is considered the safest in terms of recovery. The second recovery class includes local government GO and tax-backed bonds, federal agency guaranteed debt, public higher education bonds, single-family housing bonds, and bonds issued by transit agencies and water/sewer facilities. The third recovery class includes state and local leases and certificates of participation (COPs), as well as airports and public power distribution revenue bonds. In all of the first three classes, full recovery is expected from a resumption in debt service payments after varying periods of delay, or from a refinancing of the old debt. Fitch is not aware of any state that has permanently defaulted on its GO or tax-backed debt since the Civil War, or of any extended default on a local GO or tax-backed bond since the Great Depression. While there have been cases where issuers have abrogated their COPs or lease obligations, they have been isolated and rare.
The fourth, fifth, and sixth recovery classes consist of securities where enterprises may cease to operate but the bondholder can expect various levels of recovery from the resale value of the assets, as well as securities where bondholders do not have a lien on assets but resumption in debt service may be expected after an extended delay. The fourth class includes bonds backed by nursing homes and CCRCs, private higher education institutions, multifamily housing, public power generating facilities, and parking facilities. Toll roads would also fall into the fourth class, with recovery coming from a resumption of debt service, albeit after a potentially more extended delay than for recovery class 3 bonds. The fifth and sixth recovery classes generally consist of bonds backed by more specialized or single-use assets, with a lower expected resale value, or bonds that may resume debt service payments only after an extensive delay. Recovery class 5 includes military housing and startup toll road bonds. Recovery class 6 includes hospital, private prison, stadium, student housing, and tribal gaming bonds.
While many market participants have expressed that the existing fine credit distinctions within the lowest risk sectors are desirable, Fitch is also aware that the user base of municipal credit ratings has grown beyond the traditional base of individuals, banks, and insurance companies seeking returns on tax-exempt securities. Many of these new users of municipal credit ratings, such as derivative instrument counterparties and municipal taxable security institutional investors subject to regulatory capital requirements, may desire indicators on municipal bonds that measure expected loss on the same scale as other fixed-income investments. In the future, Fitch will seek market input in evaluating the development of supplementary credit indicators aimed at satisfying the needs of these other investors while continuing to serve the traditional municipal marketplace.
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|Date:||Jan 10, 2007|
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