By Dr. Jim Dahle, WCI Founder

I had an online conversation recently with financial advisor Allan Roth, who mentioned that he tells his clients to put no more than 20% of their bonds into municipal bonds (munis) due to default risk. He's not the only one worried about default risk either. Bill Bernstein has also suggested that there should be a limit (50%) on how much of your bond money goes into munis. I was always under the impression that the default risk there was incredibly low, almost as low as Treasuries. Since this could very much affect my own portfolio, I decided to look into it a little further.

Here's what I learned.


What Is a Municipal Bond?

Ever since the US income tax was instituted in 1913, there has been a special carve out for municipal bonds, i.e., the debt obligations of states and municipalities. The interest these bonds pay is federal income tax-free. These bonds are also usually tax-free in the state of issuance. This allows state and local governments to borrow at lower interest rates and allows highly taxed investors to earn a better after-tax return than they could on Treasuries, corporates, or other bond types. It's a real win-win for everyone (except the federal government). These bonds are often packaged up into bond mutual funds or exchange traded funds which can be easily purchased by investors. That means a highly taxed investor who holds their bonds in a taxable account will often prefer muni bonds to other nominal bond types. So far, there are no inflation-indexed muni bonds.


Flip-Flopping on Muni Bonds

I've been blogging about finances now for almost 13 years. In no other area of investing have my views shifted as much as they have on muni bonds. I'm actually surprised I'm rarely (or perhaps never have been) called out on this, but my first blog post about muni bonds basically said, “Why bother? Your bonds belong in tax-protected accounts anyway.” When I realized a few years later that, at very low interest rates, it absolutely could make sense to hold bonds in a taxable account so your stocks could grow faster in a tax-protected account, I wrote an extremely controversial post called Bonds Go in Taxable.

Then, due to the evolution of my own portfolio, I was forced to hold at least some of my bonds in a taxable account, and given my tax bracket, I first chose to invest that money into bonds that would not result in additional federal income tax each year: I Bonds on the inflation-indexed side and a Vanguard muni bond fund on the nominal side. Thus, I went from thinking, “Why would anyone own muni bonds?” to actually having a large and ever-increasing percentage of my bonds in a muni bond fund.

Now, Allan is making me rethink even that. As I write this, 40% of my bonds (and 80% of my nominal bonds) are in a Vanguard muni bond fund with intermediate duration. I use VWIUX (Vanguard Intermediate Tax-Exempt Bond Fund) and, after 2022 when it became necessary, I used a very similar tax-loss harvesting partner in VTEAX (the Vanguard Tax-Exempt Bond Index Fund). The other 20% of my nominal bond allocation is in the TSP G Fund, the shining star of portfolios in 2022. However, the G Fund doesn't earn all that much, and I haven't made contributions to it in many, many years. It has gone from being 100% of my nominal bond allocation to now just 20% of it, and it doesn't seem likely that it will ever be more than that amount in the future.

The real question is: should I be putting some of the money currently in muni bonds into Treasury bonds to minimize default risk? Let's try to decide.

More information here:

What Bond Fund Should You Hold?


Are Muni Bonds Safe? The Two Main Risks of Bonds

There are two main risks of bonds. The first is interest rate risk, sometimes called duration risk. This is the risk that your bond (whether owned directly or via a fund) loses value when interest rates go up. Since an investor could now buy a bond that is similar to yours but pays a higher interest rate, why would they pay the same amount for your bond? They wouldn't, not unless you discounted the price enough that the yield on the two bonds was equal. So, your bond falls in value until those yields are equal.

You minimize interest rate risk by limiting the maturity (and thus the duration) of your bonds. In my case, I only invest in bonds that are “intermediate” or shorter. For example, the average maturity of a bond in VWIUX is 8.1 years. Duration is related to maturity but basically tells you how much the value of the fund will drop in the event of a 1% increase in interest rates. The duration of this fund is 4.7 years, so if interest rates go up 1%, the value of the bonds in the portfolio will fall about 4.7%. Indeed, when interest rate risk shows up (such as in 2022), that is what happens. The total return of this fund for 2022 was a lousy -6.83%.

The second major risk for bonds is default risk. This is when the person, company, or government that borrowed the money from you (remember that a bond is a loan) decides they're not going to pay you. They may pay you the interest they owe late. They may not pay the interest back at all. They may not even pay the principal of the loan back. All are considered a type of default. The less creditworthy the borrower, the higher this risk and the higher the interest rate charged. Thus, peer-to-peer loans may have interest rates (yields) of 20%-30%. Junk bonds might pay 7%. Corporate bonds might pay 5%. Treasuries might pay 4%.


The Default Risk of Municipal Bonds

What is the default risk of municipal bonds and what can be done to minimize it? From 1970-2022, the default rate on munis was 0.08%. That means 99.92% of municipal bonds paid their interest and principal as agreed. That's an incredibly low default rate. By comparison, the Treasury default rate was 0%; that's the gold standard. Corporate bond default rates vary from as low as 0.38%-1% for “investment grade” bonds to as high as 4%-49% for junk bonds. As you can see, the 0.08% muni bond figure is far more Treasury-like than corporate-like. Thus, for many years investors have simply treated muni bonds like they treat Treasury bonds, essentially ignoring the possibility of default. This is particularly easy to do when using a bond fund. VWIUX owns almost 13,000 different bonds. Who cares if 10 of them default? You're probably not even losing all of the principal on most of those 10. In comparison to the risk you're taking on the stock (equity) side of your portfolio, this risk can absolutely be ignored.

Or can it?

Allan and Bill are suggesting it can't. Their argument is primarily that municipal pension funds are dangerously underfunded and that this could result in the default rate among states and municipalities rising dramatically. Since you want your bonds to be there for you in the worst of times, this would suggest that you avoid those with default risk—or at least limit them in some way. Allan and Bill, though, seem to recognize that this risk is pretty low and that it just needs to be managed, not avoided altogether.


How Much Am I Getting Paid to Run This Risk?

municipal bonds

It's not like I'm not getting compensated for taking on this risk. Let's run the numbers. Remember muni bonds are federal income tax-free and Treasury bonds are state income tax-free. My marginal tax rates are 37% federal and 5% state. Yields of the Vanguard intermediate tax-exempt and Treasury funds on the day I wrote this article were 3.19% and 3.86%, respectively. After-tax, I'm being paid

3.19% * (1-5%) = 3.03% in the muni fund and

3.86% * (1-37%) = 2.43% in the Treasury fund.

I'm getting paid an additional 0.6% after tax to invest in munis and take on that default risk. Is it worth it? It absolutely is if the risk is 0.08%. But is the risk actually higher? It was back in the 1930s.

More information here:

Should I Use a State-Specific Municipal Bond Fund?


Municipal Bond Defaults in the Great Depression

There isn't actually a lot of data out there on this subject. One of the best sources I found was a thesis paper by Marc Joffe done as part of his MPA at San Francisco State University way back in 2013. Marc notes that 4,800 municipal bond issuers defaulted on either interest or principal payments during The Great Depression. That seems like a lot, although I could not determine from the paper what the percentage of the total was represented by that 4,800. I also couldn't determine definitively what percentage of the principal was recovered by the investors. I couldn't even find historical returns for muni bonds in the 1930s.

We do know how Treasury bonds and corporate bonds did, however.


1930s Asset Returns


Not too bad, right? If Treasuries and corporates did that well, it's hard to imagine munis got killed. We also know what bond yields were in the 1930s:


Bond yields 1930s


Muni bond yields were basically 2%-4% while Treasury yields were also 2%-4% and corporate yields were 2.5%-5%. It really doesn't make sense that all of these yields were falling if the default rate was all that high. The classic study of this era was George Hempel's 1964 doctoral dissertation, “The Postwar Quality of Municipal Bonds.” He estimated that the total loss of principal and interest from muni bond defaults during the Depression years was about $100 million, about 0.5% of the total amount of outstanding state and local debt. That doesn't sound bad at all, although we have to recognize that this likely understates how it felt at the time. When a bond stops paying its coupon, you really don't know if it will ever start repaying, pay back what it missed, or even give your principal back. And you may not know for several years.

Joffe's thesis contains some interesting reading. There was a lot of muni debt as states and communities were building roads for those new-fangled automobiles. It peaked at about 35% of GDP in 1933. It is currently about 15%. There seem to have been two main causes of those defaults. The most important one was that banks were closed—sometimes for months or even permanently—and the states and municipalities had their cash in those banks. They couldn't pay the interest on the bonds—not because they didn't have the cash, but because they couldn't access the cash. This sort of scenario seems much less likely today given the changes in banking regulations and actions since that time.

Another factor was “tax rebellions.” Basically, people, en masse, refused to pay their property taxes—the major source of revenue for many municipalities. It turns out that most of those 4,800 defaults in the Great Depression were for little podunk towns, school districts, and special districts. Not big cities and states with immense power to tax their population. However, some of the larger and more spectacular ones were in Cleveland; Detroit; and, briefly, New York City. Entities in Chicago also defaulted. Each of these seemed to be precipitated by a spike in property tax delinquency rates.

Taxpayers in RevoltJoffe explains:

“Although many of the property tax delinquencies were undoubtedly the result of economic distress, the early 1930s was also a period of organized tax revolts. This longforgotten tax resistance movement is described in David Beito’s 1989 book Taxpayers in Revolt. Beito argues that the resistance was in large measure a reaction to substantial increases in property taxes during the preceding decade. This increased burden was often accompanied by stable or falling property values, since the 1920s was a time of weak real estate prices. Beito traces the history of the property tax resistance movement in Chicago where anti-tax activism was most potent. The Chicago resistance was led by the Association of Real Estate Taxpayers (ARET), an organization originally formed by relatively affluent investors, but which later attracted broad support among the city’s skilled blue collar workers worried about maintaining their foothold in the middle class. At its peak, ARET leaders hosted a thrice-weekly radio program and the organization had 30,000 members. Beito also notes that tax resistance in Chicago and elsewhere became easier when the market for tax titles collapsed.”

There was such a glut of tax titles for sale that delinquent property taxpayers really weren't scared that their homes were going to be sold out from under them to investors willing to pay off the property tax bill, because there weren't any investors with any money. This loss of revenue was a big deal since 2/3 of the tax revenue for most big cities was from property taxes. It didn't help that cities had already lost another 5% of their revenue with Prohibition.


How Big of a Deal Are Underfunded Pensions?

Allan and Bill are worried that pensions are underfunded and that they're going to make states and cities default on their muni bonds in a general economic downturn. However, Joffe suggests this isn't a particularly new problem or even a difficult one to manage. As he writes,

“During the Great Depression, many retired government workers were eligible for pensions . . . Pensions were also an issue for some cities. Estimates published in Municipal Finance indicate that before the establishment of pensions, older municipal employees would continue to report for work even though they could no longer perform their jobs (at least not to the satisfaction of contemporary management). Supervisors, guided by a humanitarian impulse rather than a concern for the bottom line, were reluctant to fire these older employees. Administrators thus reached the conclusion that it would be less expensive to pension off the older workers at a percentage of their former salary. Many cities had not yet created pension funds and those that did often failed to make actuarially appropriate contributions.”

A 1937 National Municipal League Consulting Service survey of Atlanta’s finances reported serious underfunding in the city’s pension funds:

‘It is obvious from these figures that the firemen's fund with a cash balance of $491.38 is no fund at all. Nor are the reserves of either the general or police funds even a faint approximation of what they should be to guarantee the payment from the fund of its probable obligations . . . Firemen this year who paid money into their pension fund saw it go out again immediately to pay other firemen's pensions. Their sacrifice in no way built up for them any protection. They have in fact nothing to rely on but the naked promise of the city as their security for old age. We would recommend therefore that in all the pension funds the employee's contribution be treated as a trust fund and invested for him in securities or in the purchase of an annuity.'

That said the NML consultants were not advocates of full funding:

‘We believe on the other hand that it is not necessary for a public body deriving its income from taxes to accumulate a fund as if it were a private insurance company. Unless there are some predictable sharp upturns in the curve of natural retirement, there is no reason why the City should not pay pensions out of income. The integrity and solvency of the city should be a sufficient guarantee to the employee that the city will fulfill its pension contract. In fact, if the city went bankrupt, any fund it might have accumulated would probably disappear in the crash.'

Atlanta public employee pensions at the time were generous—at least by the standards of today’s private sector. Employees could retire on 50% of their salary after 25 years of service, regardless of age. Survivor benefits were also provided. Atlanta avoided default during the Depression and evidence reviewed thus far does not attribute any case of municipal default during the 1920-1939 timeframe to employee pensions.”

Despite the recommendation of the consultants, most states actually do have dedicated pension funds. As of 2022, this is where they stood:


Underfunded pensions


Given the solid investment returns in late 2023, the current situation is likely even better than displayed here. That doesn't look too dire to me. I don't think I'm willing to give up an extra 0.6% return to decrease my exposure to that risk, especially compared to the other financial risks in my life (including equity risk and the dramatically higher entrepreneurial risks we face).

More information here:

I Bonds and TIPS: Which Inflation-Indexed Bond Should You Buy Now?


The Bottom Line

I'm never going to have more than Bernstein's 50% of bonds in munis because we've structured our bond portfolio as 50% inflation-indexed (TIPS and I Bonds) and 50% nominal. I'm a big fan of “taking my risk on the equity side,” but I'll be honest: I'm not seeing a reason to limit myself to Roth's 20% in muni bonds. If muni bonds skated through the Great Depression with a loss of only 0.5% of principal and interest, I don't have a lot of fear for a diversified portfolio of muni bonds just because Chicago can't manage its pension funds very well. Like most Vanguard bond funds, VWIUX limits itself to higher quality bonds: >90% of the bonds are rated AAA, AA, or A, and 6% more are rated BBB.

I'm not going to stay awake at night worrying about muni default risk, so I might as well get that extra 0.6%.

What do you think? Do you limit how much you invest into munis due to fear of defaults? Why or why not? Comment below!