Friday, January 21, 2011

How Safe Are Municipal Bonds?

In 1995, shortly after then-President Clinton received a "shellacking" in 1994's mid-term elections, the House Republicans had a showdown with the White House.

The Republicans were determined to make changes in fiscal policy that President Clinton was equally determined to stop.

At one point, not only did the Republicans threaten to shut down the U.S. government, but there was also talk in Washington that perhaps the federal government should defer some of the interest payments due on the U.S. Treasury obligations to reduce the budget.

The world gasped. The thought that the strongest and richest nation on the planet would stop paying interest on the money that it had borrowed was unthinkable, particularly when it had more than sufficient resources to meet its obligations.

We all know the rest of the story. Not only did the government continue to function normally, but the Republican tactic backfired, as the electorate realized that it wanted no part of any politician that would recklessly ignore its obligations. Clinton went on to win re-election easily in 1996, while the "Republican Revolution" was essentially dead.

I was reminded of this period this morning, when I read the story in the New York Times that there is quietly a movement afoot in Congress to allow municipalities to potentially file for bankruptcy.

Included in the legislation being considered would be the right to consider municipal bond holders as unsecured creditors in a bankruptcy filing, meaning that they could potentially face significant losses on their bonds:

Bankruptcy could permit a state to alter its contractual promises to retirees, which are often protected by state constitutions, and it could provide an alternative to a no-strings bailout. Along with retirees, however, investors in a state’s bonds could suffer, possibly ending up at the back of the line as unsecured creditors.

I don't know whether this is just a negotiating tactic on the part of the government to try to force government employees and their unions to reduce their pension and health care costs, but it is certainly a development worth watching.

However, the reason I was reminded of the mid-1990's showdown was the similar situation that most municipalities find themselves in. True, most are facing huge deficits, but most also have the means to maintain any and all debt obligations.

Yesterday's Bond Buyer carried a long article on subject. Here's a couple of excerpts:

In addition, interest payments on state and local bonds generally absorb just 4% to 5% of current expenditures, as was the case in the late 1970s, according to the center.

Municipal bond defaults have been extremely rare, with the three major rating agencies calculating the default rate at less than one-third of 1%, the center said. Between 1970 and 2009, only four defaults were from cities or counties and most others were on non-general obligation bonds that financed the construction of housing or hospitals.

And then there's more:

“States and localities devote an average of 3.8% of their operating budgets to pension funding,” it said. “In most states, a modest increase in funding and-or sensible changes to pension eligibility and benefits should be sufficient to remedy underfunding.”...

Some observers warn that governments in dire crisis have added to unfunded pension liabilities about $500 billion in unfunded promises to provide state and local retirees with continued health care coverage. But “it is inappropriate to simply add the two together,” the center said.

Pension promises are legally binding, but retiree health benefits are not and typically can be changed, according to the report. In addition, states’ retiree health benefit plans differ widely.

“Given the different origins, scope, and potential solutions to problems in each of these areas, calls for a 'global’ solution — such as recent proposals to allow states to declare bankruptcy or to limit their ability to issue tax-exempt bonds unless they estimate pension liabilities using a riskless discount rate — make little sense in the real world of state and local finances,” the center said in the report. “Indeed, some proposed solutions could worsen states’ long-term fiscal picture.”

If there were any defaults by a major municipal borrower, interest rates for all borrowers would soar, as creditors demanded much higher yields in exchange for more risk.

I have no doubt that the municipal market will be under some pressure in the next few weeks, as Congress and municipalities across the U.S. struggle with some unpalatable alternatives. But I still believe this represents a very good investment opportunity for longer-term investors.