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Even If A Bond Doesn

July 19, 2010 - 1:01 pm

Richard Lehmann is a Forbes fixed income columnist and publisher of two Forbes newsletters. He is author of "Income Investing Today"

The recent rise in municipal defaults has again surfaced the debate as to what constitutes a municipal bond default. Issuers and bond underwriters, as well as many bondholders want to limit the calling of a default to a failure to make interest or principal payments to bondholders when they are due.

Others go so far as limiting it to only when the trustee officially declares the issue in default. Some go so far as to say that if a bond is insured and bondholders receive back the par value, no default has taken place, just an unscheduled call.

There is some self-serving motivation in this more limited definition of default. A default label clearly affects the price at which the bond will trade and reduces the audience of buyers who otherwise could be gulled into buying such bonds due to their apparently high yield. There is also a business consideration in that, for example, a community development district trying to sell property and build houses now faces buyer resistance due to the uncertainty a bond default brings.

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We at Income Securities Advisors have been tracking municipal defaults for more than 25 years and have observed and reported on more than 3,000 municipal defaults since then. Our definition of default is a failure by the bond issuer to make timely scheduled payments to the trustee of the debt. This failure is often the first visible sign of financial distress in a market where SEC disclosure rules are not enforced. Our more conservative definition was arrived at for these reasons:

1. Market transparency demands that a buyer in due course be made aware of what would otherwise be a hidden risk in a bond. Our tracking of defaults since 1983 has shown that, in the overwhelming number of cases, once an issuer misses the first interest or principal payment to the trustee subsequent payments will be missed as well.

2. Relying on the bond trustee to decide when to declare a default is a hit or miss exercise since the trustee is under the direction of the current bondholders and the bond indenture, both of who may limit his actions in this regard.

3. Making interest payments out of debt reserve funds only disguises a default. Keep in mind that a debt reserve fund is usually created at the time of bond issuance, hence, interest payments out of reserves is nothing more than giving the bondholder back his own money.

4. In the case of insured bonds, where the interest payment is funded by a bond insurer or letter of credit issuer, the default is still the same. All that has changed here is that the victim is an insurance company rather than the bondholder.There is the added situation that many such insured defaults are staged to allow the issuer to accelerate the bonds and refund them at a lower interest rate. A bondholder then is the victim if he purchased the bond above par value and is further a loser in that he cannot reinvest the proceeds from such a default settlement at the higher yield he was getting before.

The focus of financial reporting should be providing the confidence to buyers that all information critical to an investment decision is publicly available. When the economics behind a bond issue comes into question, it is important that we not let limiting the definition of default influence the buying and pricing decision, especially when such a definition favors current holders over buyers in due course.