The number of published attacks on muni credit quality seems to grow by the day. With state and local budgets struggling to gain a foothold in a tumultuous economy, a recurring stream of articles continues to raise concern among municipal investors that there is an impending default crisis in municipal bonds. While some of these concerns are quite real, it is important to gain some perspective and consider the fact that most ‘gloom and doom’ arguments contain the same flawed assumptions.
Following is a list of consistent themes typically overemphasized by these types of articles:
They tend to extrapolate data from the same tiny number of actual bond defaults on investment-grade munis to suggest that the pattern will become far more widespread. While a number of states undoubtedly have severe budgetary problems, high quality general obligation and essential service revenue bonds possess credit strength that will protect them from default – even in the most extreme instances. In fact, only $20 billion of the nearly $3 trillion municipal bonds outstanding in the marketplace are in default. Nearly half the loans that are having credit impairment notices are speculative land secured deals – most of which are non-rated. MainLine West would never offer these bonds to our clients as they would be rejected during our due diligence and credit reviews.
They obscure the vast gulf between budgetary pressures, which are severe and widespread, and risks of near-term defaults. Bankruptcies by municipalities have been rare historically, despite examples like Orange County and Vallejo, Calif., which filed for bankruptcy in 1994 and 2008, respectively. It’s important to note that Orange County never missed a coupon payment and Vallejo continues to make good on their debt services. There has been an average of eight bankruptcies a year since 1934. According to Moody’s, the average five-year historical cumulative default rate for investment-grade municipal debt from 1970 through 2009 was 0.03%, compared with 0.97% for corporate issuers.
They confuse the very severe long-term pressures related to pension funds and retiree healthcare with near-term or intermediate-term credit risks. Undoubtedly, pension and healthcare obligations will require a great deal of adjustment and many state and local governments will be forced to move toward a less-generous formula for new hires, in collective bargaining with public employee unions. However, history has demonstrated that pension reforms tend to play out over very long periods of time, softening their near and intermediate-term impact.
They ignore distinctions between corporate budgetary crises and those of state and local governments. State and local governments possess different weapons in their arsenal than corporations in attempting to weather economic storms. Fortunately, the states seem to be making progress in that regard. According to a Bloomberg article dated March 30th, the two-year slide in tax collections that opened a $196 billion gap in U.S. state budgets has stopped, easing pressure on credit ratings and giving leeway to lawmakers as they craft spending plans for next year. The 15 largest states by population forecast a 3.9 percent gain in tax revenue in fiscal 2011. The 50 states on average may increase collections by about 3.5 percent, the first time in two years the figure is expected to grow.
The situation is not as dire as the media would have investors believe. There are over 80,000 municipal bond issuers across the U.S. Only a tiny percentage of offerings are troublesome and make headlines. Stringent credit analysis has taken on significantly greater importance in light of the recent economic challenges. In other words, investors should assure that they, and their advisors, are diligent in their investment research. Changes in credit ratings can impact the suitability of a bond for an investor’s portfolio. MainLine West remains committed to using its own credit research, flagging those issuers and deals that put principal at risk. In general, we recommend investors buy essential service bonds and unlimited taxing power, voter approved, general obligation bonds to continue to sleep well at night. Stay prudent, but stay involved in the highest quality, lowest risk, segments of the bond market.