Municipal Bond Defaults: Lessons from 2020 | Lord Abbett
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Fixed-Income Insights

While defaults were up over 2019, data suggest that the market displayed its historical resiliency in a difficult year.

Read time: 3 minutes

This article is from the forthcoming edition of the Lord Abbett Muni Quarterly.

As the COVID-19 pandemic began to batter the U.S. economy in March and April 2020, municipal bond market observers were quick to register caution. “With local economies grinding to a virtual halt, businesses closed and more than 22 million Americans thrown out of work, the fallout is rippling through the $3.9 trillion [municipal-bond] market,” noted a Bloomberg report from April 17.1 But as we have noted elsewhere, many sectors of the municipal bond market held up relatively well in 2020 amid the market and economic turmoil. While default rates did increase over 2019, the percentage of tax-exempt bonds that defaulted remained quite low as the broad municipal bond market once again displayed historic resilience in the face of sharp economic downturns.

A Closer Look

In 2020, municipal-bond defaults came mostly in high yield sectors and were not reflective of the experience of the larger municipal bond market. Total muni market defaults were up 61% at $2.2 billion; for context, that figure represents only 0.05% of the $3.9 trillion market value of bonds outstanding.2 Defaults have been low in recent years, so they were likely to go up even without the pandemic. Figure 1 shows the breakdown of defaults in 2020 by sector.

 

Figure 1. Tracking Muni-Bond Defaults in 2020

Defaults by sector

Source: BofA. Data as of December 31, 2020. Data represents percentage of the par value of $2.2 billion in municipal bond defaults in 2020. Development=Industrial development bonds. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

It’s also worth noting that some of the defaults represented in the chart were caused by factors that were not correlated with credit risk of other tax-exempt bonds. In addition, these deals were likely to default even if there had not been a pandemic and that just about all the defaults in 2020 were similar in that the stress started before the pandemic.

Defaults do not suddenly happen with most municipal bonds. Typically, there is stress for several years where the issuers ask to be allowed to break certain security provisions and use reserve funds to make debt service payments. So, prior to an actual payment default, because we actively manage and surveil our portfolio holdings, we are very aware of the level of stress for issuers and can act accordingly.

To illustrate this point, we highlight two project finance deals that defaulted in 2020. (Lord Abbett has not purchased either of these securities, and this is a sector that we rarely participate in).

CalPlant

This project, located in Willow, Calif., uses rice straw, a waste produce of rice cultivation, to produce medium density fiberboard (MDF) which can used in furniture as an alternative to wood based MDF. CalPlant bonds, $228 million issued in 2017, defaulted in July 2020, after construction delays and cost overruns that were exacerbated by the pandemic, with required modification to the plant’s machinery providing an additional headwind. The bonds were unrated.

The plant was originally expected to open in October 2019 but had already experienced construction delays prior the pandemic. Then, in March 2020, the plant’s startup, and commissioning specialist, from a contractor based in Germany, left the United States due to the pandemic, and could not return to California until August 2020. Construction was finally completed in November 2020. CalPlant made its first boards that month, but production of salable board has not begun due to challenges with straw preparation and refining systems. The equipment supplier will need to make modifications to its equipment starting in February 2021.  Commercial operation is now expected to begin in June or July 2021. However, this could be further delayed if travel from Germany to the United States is hindered by the pandemic.

RePower South

This project, located in South Carolina, takes household trash, aka Municipal Solid Waste (MSW), and converts it into a fuel call ReEngineered Feedstock Fuel (ReEf) that is a coal substitute. The company generates revenue from three sources: Tip fees to take MSW from the County, sale of recyclable commodities (plastics, metals, cardboard, paper), and sales of unrated $43.9 million ReEF Bonds were issued in 2017, and with the expectation to open in mid-2019.

Repower has faced challenges with equipment and obtaining ample feedstock. In mid-2019 the RePower South needed to modify its equipment systems in mid-2019 and needed to raise additional capital.  The 2019 financial statements said there was substantial doubt about the company’s ability to continue as a going concern. The company has a contract in which Berkeley County exclusively delivers all its MSW to RePower South. However, the volumes of MSW feedstock has been insufficient.  The company determined there was substantial uncertainty in its ability to significantly increase MSW volume in a timely manner and there was uncertainty regarding commodity prices. Management has attempted to secure additional MSW Volume. However, the project has not generated enough revenue to pay debt service and which resulted in a payment default in February 2021.

A Final Word

The experience of the two issuers highlighted above shows that there are a range of factors to consider in evaluating municipal bond credits beyond economic and sector conditions. At Lord Abbett, we have developed a rigorous research discipline to assess the credit of individual issuers in the high yield space, with the goal of identifying the characteristics that make these bonds potentially attractive investment candidates—or securities to avoid.

 

1Danielle Moran, “Muni-Bond Market Is Already Seeing a First Wave of Distress,” Bloomberg, April 17, 2020.

2Based on data from BofA and Bloomberg, as of December 31, 2020.

 

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, is a $2.2 trillion economic stimulus bill enacted in March 2020 in response to the impact on the U.S. economy of the COVID-19 pandemic.

The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness.  Ratings range from ‘AAA’ (highest) to ‘D’ (lowest).  Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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