Recent headlines trumpeting staggering budget deficits in states and cities throughout the nation have stricken fear into the hearts of municipal bond investors. California's deficit has grown to an astounding $25 billion, while Illinois is grappling with a projected deficit that could swell to $15 billion. In September 2010, Pennsylvania's capital, Harrisburg, announced its intention to default on $3.3 million in bond obligations, before their bond insurer stepped in to bail them out. Crunch the numbers and it's not hard to see why investors are feeling nervous about how municipal bond issuers are going to make good on their obligations in the face of seemingly insurmountable financial challenges.
"People are surprised because [they] get into munis expecting safety," says James Early, former hedge fund analyst and adviser of the Motley Fool Income Investor newsletter. While it's true that historically, muni bonds have offered shelter from some of the market's bigger storms, no slice of the market is immune to trouble, Early says. Fanning the flames of this uncertainty are high-profile media figures such as banking analyst Meredith Whitney, who has predicted a staggering 50 to 100 "sizable" muni bond defaults in 2011 amounting to "hundreds of billions" of dollars. Whitney says the spate of defaults will touch off a municipal bond sell-off in the coming months, stifling the economic recovery and sparking unrest as local governments are forced to cut back on services and lay off public employees.
Several critics have publicly dismissed Whitney's predictions as overblown. Bloomberg columnist Joe Mysak even wrote that Whitney's numbers were "in the realm of the fabulous." Nevertheless, after years of overspending, overborrowing, and some say, undertaxing, it's no secret that virtually every level of government is facing serious financial pressures. But will the current fiscal quagmire really equate to municipal defaults of epic proportions?
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Tom Kozlik, municipal credit analyst for Philadelphia-based financial services firm Janney Capital Markets, doesn't think it's likely. "Although the 2011 municipal market landscape will be volatile, there will not be a municipal market crisis," he wrote in a recent memo to the firm's clients. "We do not see any facts leading us to think default experience will be excessively higher in 2011." In fact, according to a January 2011 Standard and Poor's report, the number of AAA-rated counties—the highest bond rating—has actually risen from 42 in October 2006 to 67, with 20 counties making the jump in the past two years. "The large increase in the number of 'AAA'-rated counties since 2008 reflects ... in our view, the inherent economic, financial, and managerial strength of these counties, which have performed extremely well through the current recession," the report said.
Since mid-2009, only four municipal bond issuers in what are considered "safe" sectors—general obligation, tax backed, and essential services—have defaulted. That number stays low primarily because states and local governments have myriad options, or "levers to pull," as Kozlik says, before defaulting on bond payments. And default is not something municipalities take lightly, says former municipal bond analyst and author of The Bond Book, Annette Thau. Not only is the process lengthy and involved, it prevents bond issuers from accessing the critical capital markets they need to sustain operations. "They'll do pretty much anything not to default," Thau says. "They'll pay off the bonds before they do anything else."
While mass defaults or bankruptcies among "safe" muni bond issuers such as states and local governments are highly unlikely, experts say there are sectors of the muni bond market that could be riskier than others. "If we look at the municipal bond market, it's going to have lots of pockets of real strength and it's going to have pockets of weakness," says Bill Larkin, fixed-income portfolio manager at Cabot Money Management. "The risk is where there's not a direct source of revenue. The further you go away from the revenue source, the more risk there's going to be." That means because certain projects such as airports, hospitals, and lotteries tend to be lower on the food chain when it comes to public funding, they might end up being more at risk when push comes to shove budget-wise. If you're looking to stay on the safe side with your muni bonds, Larkin suggests sticking to essential municipal services, things like schools, waste water management, and other utilities. "Basically things that have to be there, that they can't shut off," he adds.
But there's a flip side: According to Larkin and other experts, while the recent muni bond sell-off might signal investor unease—muni bond funds shed almost $7.6 billion in November 2010 (the largest outflow since October 2008) after posting net inflows for the previous 22 months—it could also signal a buying opportunity for the more intrepid. According to Larkin, a large number of muni bond investors are high-net-worth retail investors looking for the tax efficiency muni bonds offer, but they are easily spooked. "They don't have as good of information to really analyze and know the municipality," he says. "People tend to oversimplify when they lack information."
That lack of information could cause skittish investors to try to unload their muni bonds, which would create a glut of supply. Mix in the low liquidity of the muni-bond market and you could have those bonds selling at a significant discount. "That's where the opportunity comes because people tend to sell the good stuff thinking that it's the bad stuff. If you're a long-term investor, it's probably not a bad place to start putting money." Buying opportunity or not, the worst thing investors can do right now could be to pull out of the muni market. "The panic is too generalized," says Early. "There are certainly some muni investors who should be panicking, but some people hear the word 'muni' these days and just sell and they're selling the good with the bad. The risk profile is different than it used to be, but that doesn't mean they're bad investments."
Despite all the uncertainty in the muni-bond market right now, one thing is for sure: Interest rates will eventually go up, and investors should be prepared. Whether the Fed starts the hike in 2011 or two years down the road, rising interest rates negatively impact bond prices. Moreover, since muni bonds tend to have longer durations, they court more interest-rate risk. "If you want safe money, no matter what you're buying, you want to focus on credit quality but you also want to look at interest-rate risk," says Thau. "I would say keep your maturities short, no more than five years, because if interest rates go up, the principal goes down significantly. Buy high-quality and keep your money short."
Lastly, the super-safe reputation muni bonds enjoy has certainly taken a hit over the past couple of months, but experts say investors shouldn't be scared away by overgeneralized reports of defaults and bankruptcies on a massive scale. "Historically, we have one of the lowest default rates, and even if that were to crank up, it's not likely going to impact the good quality parts of the municipal bond market, which is a big chunk of it," Larkin says. Especially if the economy continues to improve, however incrementally, tax revenues should start to recover giving municipal bond issuers a little more wiggle room when it comes to budgets and bond obligations. "Municipalities tend to run into the money issues at the opposite end of the cycle because they collect everything in arrears," he says, "So if you look at the past year, it was pretty much a disaster, but if you look out 12 months, a lot the these problems might end up going away themselves."