“There’s not a doubt in my mind that you will see a spate of municipal-bond defaults,” the banking analyst Meredith Whitney said on a Dec. 19, 2010, segment of CBS’s “60 Minutes.”
“How many is a spate?” correspondent Steve Kroft asked.
“You could see 50 sizable defaults, 50 to 100 sizable defaults, more,” said Whitney, 41, who made her name covering bank stocks. “This will amount to hundreds of billions of dollars worth of defaults.”
That single interview terrified investors to the point that they pulled approximately $4 billion from municipal-bond funds in the week ended Jan. 19 alone, the most since flows began to be monitored starting in 1992. The withdrawals marked the 10th straight week of net redemptions, totaling $20.6 billion.
Timing is everything and Whitney’s predictions came at an inopportune time for the municipal market. In November 2010, the Federal Reserve started its quantitative easing policy which actually boosted market yields. The Build America Bond program, created as part of the stimulus package, was coming to an end. The rush by state and local governments to issue these taxable securities siphoned away demand for traditional tax-exempt debt, depressing prices. Finally, short interest, or bets on municipal price declines, jumped more than fivefold from the end of October to Dec. 31, 2010.
Whitney’s predictions up to this point have missed the mark badly. In fact, according to Moody’s Investors Service there have been no defaults of rated issues through the first half of this year.
This is not to say that the tax-exempt issuers have not and will not in the future encounter fiscal stress. The economic recovery is tepid and state and local governments are lagging in the recovery. Add to this the end of federal stimulus and 2011 will continue to present challenges. Municipal downgrades have outpaced upgrades for nine consecutive quarters.
State revenues are improving but are still below the pre-recession peak. Pension liabilities are a growing problem, but are not seen as an immediate issue for most states. Only 10 states have combined debt and pension liabilities that exceed 12 percent of their GDP. Compare that to our federal government.
There is the additional concern that state budget difficulties will cause states to cut back on aid to smaller municipalities. But a trickle-down problem, where states encounter fiscal difficulties and cut local aid, does not necessarily mean municipal governments will default. Municipalities rarely fail to make their principal and interest payments to investors. In fact, from 1970 to 2009 there were only 54 Moody’s-rated municipal issuers who defaulted. Of those, nearly 80 percent were non-profit hospital or housing project bonds, while just three involved general obligation debt.
State and local municipalities have strong incentives to pay their bond debt. Municipalities must be able to access the financial markets in a consistent manner. In addition, debt service is a relatively small part of the budgets of most municipalities. Therefore, failure to pay principal and interest obligations does not do much to solve budgetary shortfalls, particularly when compared to the cost of such an action.
One strategy for a portfolio manager is to simply avoid the municipal market completely. This, however, might be a costly and shortsighted endeavor. Logically, the uncertainty of today’s market conditions requires more than just a superficial analysis of municipal credits prior to making an investment decision. When analyzing GO debt, determine whether the debt of the issuer is manageable. After all, a municipal bond is a loan. This analysis commonly employs a number of debt ratios that are compared to benchmarks based on regional or national averages. It is also important to scrutinize the economic viability of the community along with the debt burden of the issuer. Revenue bonds require a more extensive analysis. The primary objective is to determine whether the stream of revenue for the project is sufficient to retire and service the debt.
There is a meaningful reward for portfolio managers who do their homework and take advantage of opportunities in the municipal bond market of today. Top-performing bank portfolios generally contain a higher than average percentage of municipal holdings. They pay their way.
Mark A. Tranckino is senior vice president in the Capital Markets Group at Country Club Bank, Kansas City.
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