The municipal bond market is still healthy, despite some claims to the contrary, according to a recent research report from UBS.

Despite the “well publicized fiscal challenges facing state and local borrowers, vanishing municipal bond insurance and bouts of volatility in bond prices,” muni credit quality is fundamentally sound, the UBS [UBS] report said.

While UBS said it expects some credit deterioration and even an increase in defaults, at least among the high-yield issuers, fears of a broad credit crisis in munis is unfounded.

But the report says that the fears appear to be based on misunderstandings of the muni market and its major differences from corporate debt. Among those key differences that mitigate the risks of muni debt is limited rollover risk. Most muni debt is structured so that it need not be rolled over at maturity, which means that if credit quality or market conditions have deteriorated, the risk to investors is limited.

Other differences include revenue-raising powers by state and local governments; continued existence of municipal governments; and debt service. Scheduled payments are usually a small share of a total budget, about 5% of total general spending, and not the primary cause of the current fiscal difficulties, the report stated.

However, one outside analyst said there is, indeed, cause for concern.

“If you agree that this recession is the worse economy since the Great Depression, there is reason for muni investors to be cautious,” Chris Mier, Managing Director at Loop Capital Markets, said. The real concern is the possibility of even a few bankruptcies in this market could set a bad precedent for bondholders, he said.  Traditionally bondholders have been treated well in a bankruptcy proceeding, but a bankruptcy in the muni market (filed under Chapter 9) is relatively rare. So if the next few such proceedings do not go well for bondholders, it could dampen the market for muni investing, he said.

The UBS analysts who wrote the report could not be reached for comment.

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