Bond market tougher to call as municipalities wrestle with falling revenue

Municipal bonds are a meaningful part of many a Southwest Florida retiree’s investment portfolio as they offer special tax benefits to those in upper -income tiers. These bonds are often, but not always, exempt from federal and state taxation.

A shortened name for these bonds is “municipals” or “munis." The meaning is the same: those bonds issued by states, cities, counties and their respective agencies. The list of agencies is long: school districts, special purpose agencies, seaports and airports, transportation authorities, redevelopment agencies, etc.

These bonds were once considered to be some of the safest of investment havens. There was a sense by the buyers that an A-rated (or better) bond was truly that. But all that is changing and coming into question.

Besides categorizing munis by type of issuer, they are sliced and diced by the source of income to pay the bond: either general obligations; bonds secured by a specific source of revenue, including port fees, highway tolls, subway tolls, etc.; or assessment bonds such as those to be paid by a property tax assessment.

Once simple or, at least, once simpler, the muni market has been getting a lot more complicated. Credit quality issues and questions of possible default have made this onceincomplex investment a bit more of a gamble. The most secure muni was the general obligation bond and it generally was awarded the lowest interest rate. More frequently, buyers of munis are wanting revenue bonds as they feel that the specific source of income to pay the bond is better than a general obligation bond, which looks to overall taxation. This is a concern in states where taxation is at peak levels and the citizenry vociferously objects to further taxation. Often, these citizens are leaving the state en masse.

A few states are running a budget surplus and they are OK. Many states are running deficits, yet these debts are considered manageable in the context of the state’s overall debt burden and they are OK.

However, several states are in the proverbial dinger. Absent federal government guarantees or draconian costcutting in these states, the credit markets will eventually be closed or they will default. Not that they want it that way, it is just that the debt burden will make it that way.

California, New York and Illinois are states with the greatest challenges. For a long time, all of them — particularly California — had issues. Post the Great Recession, their problems ballooned and are getting larger daily and they are now constant media topics.

What is amazing is that California, which has a huge $20 billion budget deficit, is still able to go to the credit markets and issue several billion dollars of muni debt. And more amazing is that the premium interest rate vis-à-vis other states was not 5 percent or the like. The premium was mere 1.2 percent higher in a recent debt issuance.

How so? How can such a bad balance sheet and awful budget deficit allow such? Simply put, the buyers feel that there is little chance that the bonds will default; something in the budget will be cut before the state defaults and locks itself out of the credit markets.

During the Great Depression in the 1930s, there were about 2000 municipalities that went into bankruptcy, but none defaulted. They instead restructured their debts.

Probably the biggest bust of recent times was 1994 in Orange County, an initial default that was ultimately cured.

Because of this history, which some have quantified to be a default rate of less than a quarter of one percent for all general obligation bonds, muni buyers have traditionally preferred general obligation bonds.

The history for special project and industrial project finance has not fared as well. Some great projects have failed and revenue streams have disappeared and bond holders did not get payment.

So, bottom line, which is safer? General obligations or revenue bonds? This is where an investment specialist is of huge help and importance. Anyone can look at a credit rating on a bond and inform you. But investment firms that specialize in municipals are often ahead of the curve … they usually do their own analysis and know whether a particular muni credit is improving or deteriorating and, even if you want to take the heightened credit risk, they can tell you if you are being sufficiently paid for the risk.

As a muni investor, you might want to think about several things. Muni experts are exactly that; they are not common stock or international stock experts. They generally stick to their knitting with munis and are up to date on issues specific to this market. You might want to defer to an expert in this area.

If not, then seek counsel from your investment adviser and specifically consider the debt burden of the entity and make sure you are satisfied that the revenue stream is certain, proven and will continue even in poor economic times. 

— J eannette R ohn Sho walter is a Southwest Florida-b ased chart ered financial anal yst, c onsidered t o be the highest designation for investment professionals. She can be reached at jshowaltercfa@ yahoo.com.