This week, a research team from the New York Fed released a report that correctly notes that municipal bond default rates are far higher than normally reported. Moody’s counts 71 defaults in the past 40 years; the Fed report counts 2,521 defaults! At first blush, that seems like muni bonds are a lot riskier than we thought.

But the report serves to confirm what we have been saying for years. There are two types of muni bonds: Those sold to finance essential governmental services, and those sold to finance private business activities. A city might sell bonds to improve a water treatment plant, or build a library. Those are core governmental services. A city can also serve as a conduit and issue bonds on behalf of an apartment developer, if that developer agrees to set aside a certain number of apartments for low-income occupants.

Both of these bonds are called “municipal bonds” and both are tax-free. But one is a “real” muni bond, and the other is simply a mortgage on a privately-owned apartment building. The list of “not-real” muni bonds includes nonprofit organizations, schools, colleges, port facilities and a range of small industrial borrowers. These bonds rely on private, non-govermental entities for payment. There is also a transitional type of muni bond that is initially issued to finance real estate development costs for large tract home developers. Until such time as the community is finished and the houses are sold, bondholders rely on the large developer for payment.

These privately-backed muni bonds are the source of the vast majority of defaults. Bonds for industrial development, low-income housing, nursing homes and non-profit hospitals accounted for 68 percent of the additional defaults in the Fed team’s report. We suspect tract community bonds account for most of the rest.

Further, within the realm of “genuine” municipal bonds (the only type we buy for our clients), the general obligation law in California places those bonds outside of bankruptcy risk. Water and sewer system bonds are likewise remote from the problems developing in a fast-growing number of California cites over pension and benefits promises. Moody’s announced today a forthcoming analysis of the financial problems of California cities. In the press release was this key line:

“…Moody’s will consider a further lowering of the ratings on lease-backed appropriations and other non-general obligation (GO) debts relative to the ratings on GO debts in the state. The strength of the GO pledge relative to all others has been affirmed by some recent bankruptcy court decisions in California…”

We continue to benefit from the confusion over the various types and flavors of California municipal bonds. This confusion presents us the opportunity to earn 1-2% higher interest rates by selectively identifying high-quality local government bonds that are not at risk in bankruptcy. We buy to hold to maturity and we are 100% confident of full repayment.