Fiscal Troubles and Municipal Bonds |

Fiscal Troubles and Municipal Bonds

Posted August 18, 2012 by thomas

Last year, we took a close look at municipal bonds. Most of you are aware that these are debt securities issued by state and local government entities. Their chief selling point is that the interest you receive from these bonds is free of federal income tax, and usually free of state income tax in the state in which the muni bond was originated.

But the lousy economy has resulted in severe fiscal pressure in many communities. Cities and counties are caught between a rock and a hard place: They ran up a lot of debt during the boom times, when they thought these sweet property tax assessments and collections would go on forever. But when property values collapsed, so did property tax revenues. Sales tax revenues stagnated right along with them. And these governments are squeezed, forced to balance the need to provide vital government services, honor pension obligations to retired employees, fund pensions of current employees, and pay interest and principal payments to bondholders.

Last year, we saw Jefferson County, Alabama, file the largest municipal bankruptcy in history to that point.

Since then, as we predicted here on the blog, things have gone from bad to worse.

California, which has long been a fiscal disaster area, is ground zero. San Bernardino, California, was forced to file for bankruptcy when it came down to its last $150,000. Moody’s slashed Fresno’s credit rating amidst reports that it will be next, citing their “exceedingly weak financial position.”

According to data from Governing.com, Harrisburg, Pennsylvania just skipped about $5 million in interest and principal payments to bondholders. Central Falls, Rhode Island just filed for bankruptcy this spring. Boise County, Idaho, just got smacked by a judge for attempting to default on a $5.4 million contract with a land developer and had its bankruptcy request rejected.

And that’s just cities and counties. We’re not even counting the smaller entities that have declared bankruptcy this year.

The bottom line: You cannot take anything at the city level for granted. That goes not just for bondholders, but also for retirees, employees, those who own businesses that are vendors for city and county governments, and those who are employed by those firms.

The City Manager of Stockton, California, recently signed an order ordering city payroll officials to slash police and firefighter paychecks to minimum wage.

States have a bit more breathing room, because they have more flexibility to raise taxes than cities do. It’s a lot easier for people to flee high taxes by moving their homes or businesses to the next town rather than to the next state. But we’re getting reports of businesses even fleeing high tax states like California and New York for more favorable environments like Arizona and New Jersey. They can do this and still keep many of their relationships intact. (Hawaii and Alaska readers… life might suck for you!)

With taxes slated to go up sharply in 2013, it might be tempting for those of you in higher brackets to up your holdings in municipal bonds. Especially here in Oregon, which has a substantial state income tax to go along with the federal income tax.

We don’t disagree. But it’s more important than ever to use caution in buying muni bonds. Does that muni bond your broker is hawking have a nice, fat after-tax yield? Is it that much better than you can get elsewhere? If the yield on any given bond is high, it’s probably high for a reason: The city must sell its bonds at a cut-rate price because the markets know that risk is high.

To the extent our clients use municipal bonds or funds, we’re making a few suggestions:

Keep the maturity short, because there’s a lot of risk built into the entire bond market right now. Interest rates are at all-time lows, and they don’t have anywhere to go but up. When those rates rise, most bond prices will fall in precise tandem.
Stick to high quality. Grade “BBB” or better. When the end comes for a city, and bankruptcy is nigh, the end can come quickly.
If you are a public state, county or city employee or pensioner, avoid your own entity’s bonds. Your pension and paycheck is already dependent on your employer’s continued solvency. You want to diversify your investments and your savings. They shouldn’t all come from the same source. Remember all those Enron employees who lost their jobs and their 401(k) assets at the same time when Enron stock became worthless? The same thing can happen in a poorly-run city.
Stick to insured bonds. Some bonds are insured against default.
Diversify. Don’t rely too much on any one city or county.
Use Roth IRAs, Roth designated accounts in 401(k)s, and supplemental life insurance income retirement plans (SLIRPs) to the extent practicable. These also generally provide tax-free income in retirement, without necessarily tying you to the fortunes of any one municipality.

This is a long-cycle issue. There is a bubble to deflate, but like the housing bubble, it’s not going to deflate equally across the country. What’s ahead is a long, painful process, as our governments struggle to align their substantial obligations with available means.

It’s not going to be easy. A 2006 study found that some 94 percent of municipal pensions were underfunded. Believe me, it hasn’t gotten any better since then.

Looking ahead, we’re expecting a lot more government entities to declare fiscal emergencies. Some of them will be unable to reach agreements with public employee unions, and unable to raise taxes without causing revenue sources to flee their jurisdictions. And some of these entities will be forced into bankruptcy. We are not against municipal bonds, in the slightest. But you don’t want to be left relying on a bankrupt city, county or even state for your income.

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