Risk and Return of Industrial Development Bonds

This study examines default and recovery performance of industrial development bonds (IDBs) and evaluates whether investors have been adequately compensated for the default experience they assumed by investing in these bonds. Characterized by high default rates, IDBs experienced a turnaround after the Tax Reform Act of 1986, as found by Fitch Ratings studies in 1999 and 2003. This study, which covers the universe of IDBs, updates the 2003 Fitch study with a decade’s worth of new IDB issues to observe and with an extension of the horizon of the bonds in Fitch’s study to 25 years. It finds that the sector’s default rate improvement persisted throughout the observation period. It also finds that IDBs paid large tax equivalent yield spreads relative to U.S. Treasuries. The authors examine whether these spreads were adequate to compensate investors for the bonds’ default experience and for other risks inherent in municipal bonds.