Municipal Bonds: Reports of their death have been greatly exaggerated
Whether you’re a muni bond investor…or a user of municipal services…or a taxpayer, you need to understand what may be in store for the muni bond market. We have better news for investors than they might expect though no great consolation for service users or taxpayers.
As the litany of investor concerns in 2010 – inflation, sluggish economic growth, Europe in debt crisis – has subsided, municipal bonds have taken center stage. The Great Recession has created a financial strain on state and local municipal bond issuers, with a few commentators predicting huge losses for municipal bond investors. In an Investment Perspectives to be published in January, we will go beyond the media’s analysis to look more deeply into the municipal bond market. For now, here are our initial conclusions about
- the challenges facing issuers of municipal bonds,
- the safeguards for investors,
- scenarios in the case of default, and
- implications for our client portfolios.
Overview of the Municipal Bond Markets
The municipal bond market is very diverse and resists broad generalizations. Some reports put the number of municipal bond issuers at over 50,000, with millions of unique securities making up almost $3 trillion in value. Less than one third of municipal bonds outstanding are the direct debt of state and local governments, and of that about 9% of that is “pre-refunded” (collateralized by US government bonds)i. Most of the remainder are revenue bonds, half of which are utilities with rate-setting powers and generally less impacted by recession. Many universities, endowments, hospitals, and toll roads also issue tax-exempt bonds.
The historical experience of municipal bonds is that they very rarely default. Both the number of instances and the dollar impact have been small. According to the most recent studies from Moody’s and Fitch, two municipal bond rating agencies, the 10-year cumulative default rates for all municipals, including high yield, are 0.09% and 0.58% respectively. Going back nearly 40 years, the vast majority of issuers (perhaps over 80%) in the municipal market that have defaulted did not have taxing authority, and were either part of the healthcare (typically special care facilities) or housing sectors.
Moody’s Rated Defaults of 18,400 Rated Issuers from 1970 to 2009
Even during the Great Depression, when almost 4,800 issuers of municipal debt (7% of outstanding debt) defaulted between 1929 and 1937, most defaults did not last long and the estimated loss on the total was only about 0.5%.ii This modest impact is all the more surprising given the lack of economic stabilizing mechanisms (e.g., unemployment insurance, the FDIC) which did not then exist.
Because data is most readily available on state finances, we will focus our analysis there, commenting on local municipalities and other issuers as appropriate.
Challenges facing municipal issuers
There are two principal challenges facing municipal bond issuers today:
- The Great Recession, which has substantially reduced tax revenue; and
- The growing burden of pension and retiree health care obligations, much of which is unfunded.
The National Governors Association and the National Association of State Budget Officers recently released its biannual The Fiscal Survey of States, which presents data on the states’ general fund receipts, expenditures, and balances. Total general fund tax revenues in FY 10 were $610 billion, a 10% decline from FY 2008, with effects in all three primary sources of state revenue: personal income, property, and general sales taxes.
State and local tax Revenue by Type, Y/Y Quarterly Change
Source: U.S. Census Bureau, Barclays Capital.
A number of states entered the recent crisis with existing budget gaps and underfunded pensions already on the books. The accumulation of further annual deficits is too large to be solved by a few years of good economic growth. According to the Center on Budget and Policy Priorities, 39 states together have a projected additional gap of $112 billion for FY 2012, to produce a cumulative total of $350 billion. California, Illinois, New York and Texas are the states with the largest budget gaps for FY 2012, accounting for 50% of the total.iii
Strong support for municipal investing
Contrary to common perception, there has not been an increase in defaults. Standard & Poor’s reports that, year to date through November 1st, municipal bonds defaulted at roughly the same pace as in 2009 – a mere 0.3%. We believe that a significant increase in municipal defaults is unlikely, for a number of reasonsiv:
Low current cost of debt service. The primary reason defaults are unlikely is that the cost of servicing debt is now very low for most municipal bond issuers, with interest payments representing a relatively small part of state and local budgets. While pensions represent a growing spending pressure and large unfunded liability for some, most of the actual pension expenditures will not be made for many years.
Opportunities for revenue enhancement.Even without tax rate increases, municipal finances will improve as the economy recovers. In addition, where they can, governments across the country are raising tax rates.
Opportunities for expense reduction. State and local governments have demonstrated the willingness to make difficult choices to maintain budget balance while making full and timely debt service payments, even in very stressful financial situations. The National Association of State Budget Officers reported that 43 states cut their budgets in 2009 and 42 did so again in 2010.
Y/Y % Change in State General Fund Expenses
Source: National Association of State Budget Officers, Barclays Capital.
Cost reductions have taken the form of delayed or cancelled projects (the rail tunnel between New Jersey and New York City is a well-known example), reduced services, and reduced public workforce.
Prioritization and protection. Security for general obligation (GO) and dedicated tax bonds is very strong, provided for in state constitutions, statutes, covenants with bondholders, and local ordinances. For local municipal issuers, GO bonds are secured by their power to levy and pledge property tax revenues for debt service. In recent decades, municipal bondholders have largely escaped big losses in bankruptcy cases because much of the debt has been secured by special liens and tax pledges that are protected.
These elements of protection for municipal bond investors are reflected in municipal bond ratings. In November 2010, Moody’s Investors Service affirmed the A1 rating and stable outlook on California’s outstanding general obligation bonds, in spite of the near hysteria around the state’s large deficits.
Implications for client portfolios
The fundamental truth of investing is that we must be willing to take risk to achieve a return, and the question should be whether all of the factors discussed above are reflected (albeit imperfectly) in market prices. That is, do the returns offered compensate for the risks that are present? It seems so – by almost every measure, municipal bonds are priced attractively relative to U.S. Treasuries and U.S. corporate bonds. In the current environment, the longer the maturity and lower the credit quality of a municipal bond, the more attractive its price is relative to historical averages. Consequently, Aspiriant takes an opportunistic and broadly diversified approach to municipal bonds, which includes allocations along both the maturity and the credit spectrums.
Our confidence in our approach to municipal bonds is bolstered by the diversity of the municipal market and the absence of the kind of interdependence which drove the financial crisis in September 2008. In many cases, a single municipality will issue several series of bonds, each supported by a different source of revenue. For example, the same city might issue GO bonds, utility revenue bonds, and bonds supported by a first lien on a citywide sales tax. Although the credit quality of each of the bonds is largely affected by the local economy, unique factors will influence the specific repayment scenarios.
Barclay’s Capital High Grade Municipal, High Yield Municpal,
and Municipal Taxable Indices - Market Value % by Source and
Still, there are certain common vulnerabilities – slow economic growth, still falling real estate values in some areas, and pension obligations, to name a few – and we may see an increase in the incidence of default among certain types of issuers, notably among smaller, non-essential projects from economically challenged areas, with cash flows that are not supported by taxes.
However, limiting investments only to tax-backed and essential service bonds would cut out a large and attractive portion of the market. In fact, this could be a counter-productive approach with yields on short-duration, high quality bonds currently offering a negative real (after inflation) rate of return.
Jason Thomas, Ph.D., CFA
Chief Investment Officer