Assessing Municipal Bond Default Probabilities

by Matthew Holian of San Jose State University, and
Marc Joffe of Public Sector Credit Solutions

April 30, 2013

Abstract: In response to a request from the California Debt and Investment Advisory Commission, we propose a model to estimate default probabilities for bonds issued by cities. The model can be used with financial data available in Comprehensive Annual Financial Reports that cities are required to publish. The study includes modeled default probability estimates for 261 California cities with population over 25,000. Our model relies on case study evidence, logistic regression analysis of major city financial statistics from the Great Depression – the last time a large number of cities defaulted – as well as logistic regression analysis of more recent city financial statistics. Independent variables in our model include (1) the ratio of interest and pension expenses to total revenue, (2) the annual change in total revenue, (3) the ratio of general fund surplus (or deficit) to general fund revenues and (4) the ratio of general fund balance to general fund expenditures.

JEL Classification: H74, C35, R51.

AMS Classification: 62M20.

Keywords: municipal bonds, municipal bankruptcy, default probability model.

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