Municipal Bonds—Our Confidence is not Unwarranted

With real estate prices having fallen significantly over the past few years, many market pundits have begun to point to municipal bonds as the potential next shoe to drop. While we see the pressures placed on municipalities by lower asset values, we believe most have sufficient room to cut spending and save their bondholders and themselves from the grief of default. However, municipalities do default. Recent examples such as Orange County, Calif., and Jefferson County, Ala., serve as reminders of this possibility. In the most recent case, Harrisburg, Pa. city leaders voted to default on their bonds and let the insurer pick up their slack, but the state of Pennsylvania stepped in and allowed the city to take an advance on future funding to keep the city out of default.

Looking at the study, “U.S. Municipal Bond Defaults and Recoveries, 1970-2009,” published by Moody’s Investor Service in February 2010, municipal bonds have shown the ability to survive through the market pitfalls of the past 39 years. According to the study, all municipal bonds rated by Moody’s have experienced a cumulative default rate of 0.09% in any 10-year period. That is to say, nine of every 10,000 municipal bonds rated by Moody’s have experienced a default. By comparison, corporate bonds rated Aaa, the top rating available from Moody’s, have experienced a default rate of 0.50%. That is more than five times the level of the municipal bond group as a whole. In fact, the default rate on Baa rated municipal bonds is 0.16% over a 10-year period. According to this statistic, the default of a municipal bond rated Baa is less likely than that of a Aaa-rated corporate bond. We have provided a table of ratings below for clarification.

Given the tough financial situation facing municipalities and the low interest rate environment, we have struggled to find municipal bonds attractive enough to purchase. This is more a byproduct of the interest rates than any fear of potential default, although we did increase our quality criteria for client liquidity bond purchases. As you may have seen in your own accounts, many municipal bonds experienced downgrades over the past two years. Much of this is because municipal bond insurers have suffered financially from their practice of insuring real estate related securities. As mortgages failed, these insurers had to pick up the bill. At this time, there is only one municipal bond insurer actively writing insurance policies, and several of the major bond insurers have failed. In order to avoid future problems in that regard, we have added the requirement that all municipal bonds purchased for liquidity must have a rating on the underlying insurer. No longer will the insured rating suffice. This change in criteria is likely to keep bonds from falling as their ratings are downgraded for reasons unrelated to the fiscal health of the entity ultimately paying the interest and principal.

Another interesting statistic is the recovery rate on those bonds that experienced default. According to Moody’s, only 54 municipal bonds rated by the company failed during the period 1970 to 2009. Of those defaulting, the average ultimate recovery rate was 67.04% of the face value of the bonds. This means one would have received 67 cents on the dollar on average in the event of default. While a 33-cent per dollar loss is not a good thing, it is better than losing the entire investment. However, many of the defaulted bonds paid the full face amount to the holder after default.

During times of financial stress, we have looked to purchase only bonds considered a general obligation of the issuing municipality. This would include mainly state, county, and school board bonds. Considering the aforementioned Moody’s study, of the 54 rated bonds defaulting in the 39-year period covered by the study, only three were general obligation bonds. Looking at the statistics as published, of all general obligation bonds rated by Moody’s, the default rate was 0.01% in a 10-year period of being rated, or only one in 10,000 defaulted. In the past, we have purchased municipal bonds that were not general obligation bonds. In fact you may still own some of them. Be assured, we review these bonds and will notify you if we feel they should be sold.

In considering why the bonds so infrequently experience failure, you should consider the sources of financing for a municipality. Generally, a municipality has but one source to fund its spending and that is through the bond market. A bond default leaves a lasting stigma and can increase the cost of borrowing for years in the future. This causes the municipality to do anything possible to avoid default. In many cases municipal bonds obligate the issuer to increase taxes, within limits, to meet their interest and principal payments. Of course this could force municipal leaders out of office when voters see their taxes increase, but this also serves to hold their feet to the fire when considering spending initiatives.

By now you may be shaking your head, thinking, “Wasn’t part of the financial turmoil of the past two years caused by the rating agencies?” The answer is yes. However, the rating of mortgage-backed securities, for which the rating agencies took so much heat, was a new service for the rating agencies. Where the agencies went wrong was in advising issuers of the products on how to include highly risky assets and still get the highest ratings. The business of rating bonds was the bread and butter of the ratings industry since its inception. The statistics shown above should be sufficient proof of the benefits of the rating system on municipal bonds. Interestingly enough, we have not seen the same statistics on mortgage-backed securities and their ratings.

To further make the case against the likelihood of impending municipal default, we have looked at the revenues and spending habits of several major municipal issuers since 2007. Most states were in the black in 2007, but falling state revenues have negatively impacted budgets. For instance, California seems most negatively impacted with a decline of 12.5% in revenue since 2007 while spending only contracted by 3.7% as of 2009. Other known cases of state budget deficits include Illinois and New York. However, many smaller municipal governments within these states are operating well with few signs of distress. Ultimately, there is no substitute for doing some research before making any investment decision. What seems odd about the recent news concerning municipal bonds is that all bonds in the category are being lumped into the same category as potential failures. Bonds issued by Aaa-rated issuers such as Georgia and Maryland are being priced lower on the news of stress in California and Illinois. Reasonable investors would not hear a news story of impending distress at one computer manufacturing company and sell all of their Information Technology stocks without first investigating the impact on their other holdings. We see this as a buying opportunity and have been working to fill client fixed-income needs in this environment.

Of course, as is often noted in the business of finance, past performance has no bearing on future results. However, we believe the recent news of impending doom in the world of municipal finance is excessive.

Bond Buying Criteria

Disclosures

This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.