Municipal Bond Default Fears Inflated

Municipal Bond Default Fears Inflated

by Kevin Kroskey, CFP, MBA

(As seen in the Bath Country Journal)

News coverage on state and municipal economic issues has been prevalent over the past few months with some calling for unprecedented levels of defaults on municipal debt and yet another financial meltdown. Investors pulled $1 billion from municipal bond funds over the prior week, ending March 9th, according to the fund research firm Lipper. This marked the sixteenth straight week of outflows now totaling more than $27 billion.

 The municipal market is less liquid than other bond markets for corporate or government bonds, since the municipal market is comprised mostly of individual and not institutional investors. The media has long know that ‘bad news makes good copy,’ and it is evident these headlines are influencing individual investors to be reactive rather than proactive. Is this pervasive fear warranted?

 Historical Municipal Defaults

 In the table byou can see the historical default rates from 1970 through 2009 courtesy of Moody’s. Notice that investment grade municipals carry a historical default rate of 0.06% compared to 2.50% for investment grade corporates. Further, AAA municipals did not default at all.

Municipal & Corporate Default History (1970-2009)

   

Muni

 

Corporate

AAA

 

0.00%

0.50%

AA

 

0.03%

0.54%

A

 

0.03%

2.05%

BBB

 

0.16%

4.85%

Investment Grade

 

0.06%

2.50%

    

Source: Moody’s Investors Service April 2010

 The term default brings fear to most investors, but a default may not mean that investors lose money. Recovery rates for municipal defaults are much greater than those for corporate defaults, as it is much easier for corporations to file bankruptcy and discharge debts. In many municipal defaults, investors are made whole but may not be paid in accordance with the terms of the bond. Thus the term default would still technically apply.

 General obligation bonds are bonds backed by the general taxing authority of the municipality. From 1970 through 2009 there were only three general obligation bond defaults and two of these had a 100% recovery rate.

 Revenue bonds are tied to specific projects. More than 70% of the defaults over this time period occurred form revenue bonds tied to housing and healthcare. Essential services such as sewer or power in stable or growing municipalities are generally rated lower than general obligation bonds yet are still viewed as very safe.

 Current Economic Conditions

 The Great Recession caused a drastic decline in tax revenues and also a simultaneous increased need for the services provided by states and municipalities. Estimates of Ohio’s two-year operating budget deficit range from $6 billion to $8 billion in total or $3 billion to $4 billion per year. The human brain has a difficult time understanding large numbers, so thinking in terms of percentages often helps better understand the magnitude of the problem. According to the Center on Budget and Policy Priorities, Ohio stands at an 11% shortfall for 2012 to 2013 from the prior two-year fiscal budget.

 States and municipalities have had to utilize reserves, make budget cuts, raise taxes, and use federal stimulus dollars to fill recession-induced shortfalls. Most of the federal dollars will have run out by the end of 2011. However, these deficits are cyclical in nature and will ease as the economy continues to recover and as the unemployment rate continues to decline.

 State tax revenues have already seen a bottom and are on an increasing trend. Yet this fact often goes unreported or is at least vastly outweighed by negative press. The Nelson Rockefeller Institute of Government recently issued a preliminary report for the fourth quarter of 2010, stating that state tax revenues were up 6.9% from the year prior.

 Ohio and other states also are having important debates about compensation and benefits paid to public workers and their collective bargaining rights, often citing how labor contracts tie a municipality’s hands in managing budgetary concerns. While there is no doubt truth in this position, it is important to discern the shorter-term cyclical deficits caused by the recession from the longer-term structural deficits caused by pension obligations, healthcare benefits, and bond indebtedness.

 The longer term deficits seem to be garnering more attention in the news and are likely being interpreted by investors that states are in too deep and recovery without default is unlikely. It is much more likely that the recovery will be slow but manageable in conjunction with additional action.

Implications for Investors

Yields and Maturities of Various Fixed Income Instruments

 

Treasury

CD (FDIC)

Corporate

(AA Rated)

Taxable G.O. Muni (AA Rated)

3 yr

1.10

1.47

1.87

2.21

5yr

2.03

2.50

2.86

3.24

10yr

3.36

 

4.31

4.59

20yr

4.27

 

5.37

5.73

Source: Bloomberg & MMD as close of 3/10/11

 Bad investor behavior has caused prices of municipal bonds to decrease in relation to other fixed income assets. The decrease in prices of municipal bonds has sent yields markedly higher over the last few months. This can presents a buying opportunity for the savvy investor who can temper the headline risk.

 Purchasing a diversified portfolio of high-quality general obligation and essential service revenue bonds with solid credit ratings in stable or growing communities can allow an investor to lock in higher yields. If held to maturity, purchasing these bonds individually rather than in a bond fund will allow the savvy investor protection from further price swings.

Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs. Kevin can be reached at 330-777-0688 or found online at www.TrueWealthDesign.com.