Municipal Bond Forum

Pre-refunded bonds are securities that are typically escrowed in U.S. Treasury bonds or other obligations of the federal government. The bonds in escrow come due on the pre-refunded date and represent the ultimate in safety. There is virtually no chance that these bonds will not be redeemed on their pre-refunded date. In rare cases, however, they may be called by the issuer prior to the pre-refunded date, if the optional call features were not defeased at the time of escrow.

It wasn't only municipal bond rates that skyrocketed during that period. Short-term CDs and Fed fund rates, at one point, exceeded 20%, while 30-year Treasury bonds yielded over 15%. 

The major cause was the oil crisis of 1979, which was characterized by gas shortages and soaring prices at the pump. Inflation flames were further fanned by dramatic increases in the money supply, as the Federal Reserve artificially fixed short-term interest rates below the rate of inflation.

These extraordinarily high rates did not begin to retreat until Paul Volker was installed as the new Fed chief and immediately raised short-term interest rates by 200 basis points. This had a chilling effect on the economy. During the period of recession that followed, interest rates on all bonds began a long, steady decline.

The classic study of municipal defaults in the Great Depression was written as a doctoral dissertation by George Hempel in 1964 entitled, "The Postwar Quality of Municipal Bonds." Hempel found that 3,252 existing issues were in default as of 1935, the height of the Depression. Our modern rating systems by S&P and Moody's emerged as a result of this study. Prior to the Depression, great numbers of issuers were rated in the top categories, “Aaa”/“AAA” which obviously did not reflect the true risk. The tougher standards implemented by the rating agencies since that time have helped to enforce better financial practices and have provided more meaningful guideposts than were available in the 1930s.

For example, audited financial statements were not readily available until even the 1980s. Today, thanks to pressure from the rating agencies, it is rare to find a unit of local or state government that does not provide annual financial statements that are not in conformity with rules delineated by the Government Accounting Standards Board (GASB), the Government Finance Officers Association (GFOA), and the rating agencies. The transparency brought about by modified accrual accounting, as reflected in local government Comprehensive Annual Financial Reports (CAFRs), now acts as a method of discipline to insure that both professionals and the public can better hold government to account for its financial practices and results so that a repeat of the default incidence in the Great Depression never happens again.

It is encouraging to note that Hempel estimates the total loss of principal and interest resulting from defaults during the Depression years to be approximately $100 million, or about .5% (less than1%) of the average amount of state and local debt outstanding in this period.

Hempel's study has also been used by the municipal bond insurance industry to develop their assumptions regarding the likelihood of municipal default. While the insurers have suffered from risks undertaken in the structured finance sector, their scorecards in municipal finance have been strong.