Stormy Weather

If you’ve ever lived in Florida, you know that we have periods of turbulent weather. In the summer of 2004, Hurricanes Charley, Frances, and Jeanne swept through Central Florida in rapid succession. Adequate preparation and a little luck separated those of us who escaped with little damage from those who unfortunately suffered serious losses. Currently, there is some concern that storm clouds are forming again, but this time in the municipal bond market. If you’re concerned about the possibility of inclement fiscal weather, read on.

In the fourth quarter of 2010, investors sold approximately $35 billion of the $2.9 trillion invested in municipal markets. The overall tax-free market declined in value by roughly 4.17% in the quarter (high quality, short-term bonds declined only 0.30%), making them the worst performing segment of the fixed income asset class in 2010. The selloff was attributable to a combination of events – a perfect storm of sorts. Most importantly, interest rates rose and all fixed income performed relatively poorly. Additionally, the expiration of the government subsidy program “Build America Bonds,” created an unusually large amount of supply that had to be absorbed by the market. Finally, as the Bush tax cuts were extended, the boost that the municipal market expected as a result of higher taxes never materialized. Investors now wonder whether the municipal market is the safe haven that it once appeared to be.

Historically, municipalities have been overspending, over borrowing and under taxing for years. While this pattern is marginally sustainable during economic expansions as tax revenues rise, it’s not sustainable during downturns when revenue is depressed. The Great Recession wreaked havoc on state and municipal coffers from many fronts. In states where income taxes apply, high unemployment suppressed tax revenue. States that relied on sales taxes were hurt as consumption was constrained. Counties and cities that depended on real estate taxes were squeezed as values and the associated taxes decreased. In 2011, state budgets have projected shortfalls ranging from $120 to $140 billion.

Over the years, investment grade bonds have been very safe with miniscule defaults. Statistically speaking, from 1970 through 2008, the default rate on AAA/AA municipal bonds was between 0.00% and 0.06%. Lower credit quality of single A had default rates ranging from 0.03% to 0.23%. The entire investment grade universe (consisting of AAA, AA, A, BBB) had a default rate ranging from 0.07% to 0.20%.

Non-investment grade municipal bonds and unrated municipal bonds had a much higher historical default rate. These are the instruments expected to experience some difficulties in the future. There is also an increased probability of default, regardless of credit quality, the longer the bond has remaining to maturity. That’s because with longer maturities there is more time for a municipality’s balance sheet to deteriorate.

When a corporation defaults it often declares bankruptcy and dissolves. Municipalities that default do not dissolve and they must restructure. For municipal bonds that have defaulted over the last 30 years, the average recovery rate has been 68% while corporate debt realized a recovery rate of 40%.

 

If history is any indication, economic stresses will have to accelerate materially to have any significant impact on the municipal market. And this still holds true even if we assume that default rates on investment grade bonds are ten times that of recent historical averages, which equates to a default rate of 2%. Assuming a below-average recovery rate of 50%, the net loss to a diversified portfolio would be 1%. A loss of this magnitude would be completely offset by dividend yield. Under this pessimistic scenario, an investor in diversified investment grade municipal bonds would experience less principal erosion than if interest rates rose two percentage points.

Public Pensions and Fiscal Prudence

There is no question that the municipal market faces numerous challenges. Bond issuing entities have to either return to fiscal balance through a combination of cost cutting and tax increases or to default on their debt. The relatively few municipalities that have historically defaulted on debt have found that capital markets have a long memory and these towns, cities, or states are effectively barred from raising necessary capital for extended periods of time. As most states have a balanced budget amendment and are constitutionally barred from spending more than they collect in taxes, access to capital markets is essential to fund ongoing operations. Shutting off access to capital markets would be economic suicide.

Since municipalities want to retain access to the capital markets, it’s much more likely that fiscal prudence will prevail - less by choice than necessity. As a result of chronic underfunding, and to a lesser extent reduced pension plan values from the recent stock market correction, public pensions and health care plans are collectively underfunded by 1.0 to 1.2 trillion dollars. As current and retired public employee pensions and health care expenses make up a large part of structural imbalances, these costs must be brought under control.

Public employee pensions, while often earned over years of hard work, have also occasionally been abused. The benefits offered are far in excess of private sector workers and may be out of line with the economic realities of the 21st century. As many state and local employee benefits are controlled by union contracts, any reductions will be difficult to attain.

Legislative

From a legislative relief standpoint, Republican Governors and lawmakers pledged spending cuts as part of their election platforms. To make good on these promises they have apparently targeted organized labor’s public employee unions. What’s occurring in Wisconsin is the first highly publicized test for many state governments. The state is asking employees to contribute to their health care and more toward their retirement plans. Wisconsin, and more recently Ohio, is also attempting to strike at the core of union strength by limiting its collective bargaining ability for pensions and health care. If the strong momentum continues, other states will be emboldened to follow suit as they grapple to reduce budget deficits.

For the 24 states that allow judicial relief, Chapter 9 bankruptcy protection may be a viable alternative. Vallejo, California the small town that badly mismanaged its finances, is now emerging from Chapter 9 and although they received the judicial authority to reduce current and future pension obligations through bankruptcy, they lacked the political will to do so. They did however dramatically reduce ongoing and future health care costs. Their example illustrates that bankruptcy, or the threat of it, can be a useful tool in union negotiations to restructure outstanding obligations.

 

Municipal Bonds – In Summary

It is not our intention to gloss over the significant challenges that the municipal bond market has and will continue to face. However, from a purely economic standpoint it is far more likely that changes in state and local policy, specifically cuts in services and benefits and increases in taxes, will remedy the situation rather than defaults on debt. Indeed there are signs that the fiscal imbalances are already beginning to correct. From the fourth quarter of 2009 through the fourth quarter of 2010, state tax revenues advanced 6.9%. Additionally, for the first time in thirty years, states have begun slashing their budgets.

For those of you managing your own municipal portfolio, the safer municipal bond issues are essential service revenue bonds and general obligation bonds. Essential services include public schools, wastewater management and utilities. Private hospitals and airports are generally considered to have a moderate amount of municipal risk, while the riskiest segments of the market are issued by one-time issuers for things like golf courses or multi-family housing developments. You may also want to limit your exposure to bonds of the more financially strapped states of New Jersey, Pennsylvania, Illinois and California. Credit enhancements, or insured bonds, from companies like AMBAC and MBIA should be materially discounted, as these companies lack the capital to weather a storm.

If we are in for stormy weather, regardless of its magnitude or duration, there are steps that can be taken to mitigate any damage to your investment property. Academic evidence supports that your municipal bond portfolio will provide the highest probability of success in a difficult market environment if your portfolio is:

Well diversified Structured through stringent credit analysis Invested in high quality instruments Comprised of short to intermediate average maturities

Storms in nature, and in finance, result from a series of conditions that enable their genesis. They develop, build, shake the walls, and pass, leaving clear sunny days. Quality construction allows us to enjoy the eventual return of sunshine without the need to rebuild.

We are the largest fee-only financial planning and investment management firm in Florida.