The popular media has finally woken up to the troubling financial holes which certain cities, counties, and states (as well as countries . . . remember Greece?) have dug for themselves. What was previously a slow trickle of anguished assessments from a handful of knowledgeable critics has dramatically escalated following a recent 60 Minutes interview with respected analyst Meredith Whitney (view the interview here). Members of the media bandwagon now race to out-do one another with bombastic predictions of municipal bond Armageddon and impending financial doom.
BSW has been concerned about the upside-down finances of certain cities, counties, and states for several years now – and the situation does pose a real threat to financial markets and the (still) nascent economic recovery. In fact, the current level of concern and hand-wringing serves as a welcome validation of BSW’s approach to municipal bond fixed income investing, which can be summarized in the following five points:
First, focus on tax-backed, general obligation (GO) bonds from states/cities/counties with healthy balance sheets. GO investors are at the front of the payment line. Second, look to bonds backed by the revenue of essential services (water, sewer, power), again in municipalities with healthy balance sheets. Third, “credit enhancements” via bond insurance are worthless. If the underlying issuer or project is not financially viable on its own footing, steer clear! Fourth, avoid (like the plague) non-essential services revenue-backed bonds, such as golf courses, football stadiums, swimming pools. These are just junk bonds riding the coat tails of the municipality’s credit rating and taxing authority — all bonds are NOT created equal! Fifth and finally, diversify. Just because an investor is a California resident, they shouldn’t have all their fixed income investments in California bonds – do not let the tax-tail wag the investment dog.
So, while the media has raised valid concerns about municipal finances, it is important to put those concerns in the proper context and avoid generalizations that oversimplify reality. A few more points to consider:
- Since 1970 municipal defaults have been very rare events, just 54 among the thousands of issues rated by Moody’s, for example, and nearly 80% of these were in the health care and multifamily housing sectors. Investment grade corporate bonds default at 40 times the rate of municipals over 10 years.
- Defaults among general obligation (GO) issues are very rare for a reason; the legal authority and obligation to collect and raise taxes is powerful. Property taxes, at just 1%-2% of the total property value, are eventually paid.
- Legally, states are sovereign entities and most cannot declare bankruptcy and have a tremendous ability to levy and raise revenue.
The real elephant in the room with regard to municipal finances, which is still rarely discussed in the media, is underfunded pension liabilities. Underfunded pension liabilities are when states/cities/counties owe more to their current and future pensioners then they have money to pay. Case in point: California’s state pension fund, the behemoth of US state pension programs, is underfunded by an estimated $500 billion! Sadly, though, this situation has a logical outcome, and it will look a lot like what happened in Greece following the European Central Bank’s imposed austerity measures. In simple terms, public employees are going to be forced to accept lower retirement benefits or work longer for the same outcome. The retirement and health care benefits (example: defined benefit/pension plans) of public sector employees are often so disconnected from their private sector employee equivalents (example: defined contribution plans) that, when push comes to shove, it is highly doubtful the electorate will agree to foot these grossly underfunded bills.
Municipal bonds, as opposed to collateralized debt obligations and other synthetic instruments, are not weapons of mass financial destruction. Yes, there will be some cities and states that fail to make bond payments and others that will be forced to make some very, very unpopular choices, but it is very unlikely that municipal bond troubles have the potential to cause as much collateral damage as the circa-2007 shadow market of 30-to-1 levered derivatives that were just forms of taxpayer-subsidized gambling by unscrupulous investment banks. As always, if you have any additional questions or concerns about your portfolio, please contact BSW. We are happy to help.
-David Wolf, Chief Investment Officer