Municipal Bond Primer – Part 2

We continue our discussion of municipal bonds in Part II of our series.

General Obligation Credit Bond Risks

Any investment carries risk. In the world of finance, the reward you get should be commensurate with the risk. That is why United States Treasuries generally pay the least yield, the theory being that the Treasury can always print more money to pay off its obligations. Thus, unless the Federal government fails, you will get your investment paid back hence the lowest risk.

Municipal bonds (munis) are not backed by the “full faith and credit” of the Federal government so they are not as safe as Treasuries. However, some munis are backed by the taxing power of State governments making them much less risky than corporate bonds. These are generally called general obligation munis and they tend to be the “safest” of municipal bonds.

The fact that general obligation municipal bonds are safer than corporate bonds doesn’t mean they carry no risk. There are many State and local governments that are in dire financial straits right now. While most people believe that general obligation bonds can’t fail because either the government entity will simply raise taxes to pay them, or the Federal Government will bail them out, it is by no means certain that will always be the case. Moreover, a government could in theory change the terms of its General obligation bonds and defer payment of its interest.

Examples of general obligation bond defaults include New York City in 1975 and Cleveland in 1978. In the case of New York, the City defaulted on its debt and gave bondholders the choice of sitting still for a moratorium on payments, or exchanging their bonds for new paper that would later be converted to cash. Eventually, creditors were paid in full for both New York City and Cleveland, but the interim period was not a good time for the bond- holders.

For individuals approaching or in retirement that rely on the income from municipal bonds, not getting your money back in a timely manner can be extremely stressful and the interruption of cash flow can be life-changing. The point of this discussion is not to denigrate the benefits of general obligation bonds, but simply to point out that they do carry some risk — a point that is not usually addressed by the institutions that are selling these bonds, or the government entities that are raising capital through their issuance.

A more current example of the risk in general obligation bonds is the State of California. On May 29, 2009, Fitch Ratings changed its outlook to negative from stable on California's long-term general obligation bond rating of A, citing growing concerns with the state's widening budget and cash-flow deficits. If the state legislature fails to act quickly, other actions are likely, Fitch said, adding that it’s “A” rating depends on the state's ability to find solutions to its cash flow and budget problems amid the weak economy. Fitch said in a statement. "While there appears to be consensus for quick action by the legislature, should it be delayed or fail to materialize, further rating actions may occur.”

We do not currently recommend California General Obligations and have no intent to at this juncture due to our philosophy of not chasing yield in the fixed-income side of a portfolio. For subscribers who have investments in California General Obligations, you should be aware that although the principal and interest on all GO bonds are paid out of the State’s general fund, the State Constitution provides that all state revenues shall first be applied by the State for support of the public school system and public institutions of higher education. The California bondholders are next in line.

If you own or plan to own any General Obligation, we recommend you request from the issuing entity a copy of any specific constitutional or statutory protections that are afforded the debt holders.

Revenue Bond Risks

Revenue bonds, a different type of municipal bonds, are more risky than general obligation bonds because their repayment is dependent on specific revenue streams such as user fees (e.g. highway tolls) or lease payments.

In 2003, Fitch Ratings published a study that covered municipal defaults. There are a few important points to be gleaned from their study. First, default rates varied significantly across municipal sub-sectors with industrial revenue bonds having a cumulative default rate of 14.62%; multi-family housing 5.72%, and non-hospital related healthcare 17.03%. These three sectors accounted for 8 percent of all bonds issued but 56 percent of defaults! Safer bets were education and general-purpose sector bonds that accounted for 46 percent of issuance but only 13 percent of defaults.

The study also concluded that there was a moderate correlation of default risk with economic cycles. Not much of a surprise there, but what is noteworthy that a one-year lag produced a higher correlation. Given that we are about one year after the beginning of the economic downturn, we expect to see more and more defaults in this area. In a sign of the times, Moody's recently assigned a "negative outlook" to the creditworthiness of all of the nation's local governments. That was an unusually broad and sweeping generalization that Moody's defended on the grounds of the magnitude of the recession.

Some good news from the Fitch study was that defaulted municipal bonds have a fairly high recovery rate of 68.33% based on the number of defaults. But it can take time.

Next month, we will continue our discussion of municipal bonds by addressing the issues associated with owning individual municipal bonds or bond funds.

* * *

To learn how to subscribe to The Retirement Advisor Newsletter, visit our web site where you can download a free issue with instructions on how to subscribe. Subscribers are able to obtain all of our back issues at no extra cost.

Click to Subscribe Now

Don't Delay Your Financial Health Any Longer!

Table of US GDP Growth - Gross Domestic Product By Quarter

Table of US GDP Growth

The US Economy measured by gross domestic product (GDP) contracted at a 1.0% annualized rate in Q2-2009. This marked the fourth straight quarter with GDP contraction that has not happened since records began in 1947.

Quarter	Q4 07	Q1 08	Q2 08	Q3 08	Q4 08	Q1 09	Q2 09	Q3 09
GDP Growth %	(0.2)	0.9	3.3	(0.5)	(5.4)	(6.1)	(1.0)	??

For more information about the US economy, our take on the data plus our model portfolios subscribe today to get our just published August 2009 issue of The Retirement Advisor.

We are very proud of our results:

The Retirement Advisor Portfolios	Dollar Value on 7/31/09	Change
Model Portfolio 1	$197,717	(1.1%)
Model Portfolio 2	$211,427	5.7%
Model Portfolio 3	$230,970	15.5%
DJIA 12,501.52 on 1/1/2007	$8,447	(32.4%)
S&P500 1,418.30 on 1/1/2007	$919.32	(35.2%)

The Retirement Advisor Model Portfolios all began with $200,000 on 1/1/2007

At the Retirement Advisor, we have consistently advocated against “chasing” asset classes that have already risen significantly. Likewise, we also do not believe in abandoning positions simply because they have declined in value. Instead, we believe our subscribers should focus on determining their most suitable asset allocation and focusing on ensuring their portfolio meets that goal.

Our three Model Portfolios are designed to provide a framework that investors approaching or in retirement can adopt for their asset allocation. For those interested in The Retirement Advisor Model Portfolio 1 (up 10.4% YTD), studies have shown that a balanced portfolio with 50% in a broadly diversified basked of equities and 50% in fixed income, has a 98% chance of success of lasting 30 years with a 4.0% annual withdrawal rate.

The Retirement Advisor Model Portfolio 2, with about 30% in equities (up 6.8% YTD), does not have the same potential upside as Model Portfolio 1 but it allows you to retire with less volatility than Model Portfolio 1. We believe that subscribers will be able to implement a 3% per year withdrawal rate from this portfolio.

For those investors with no tolerance for the volatility of the stock market, The Retirement Advisor Model Portfolio 3 (up 2.8% YTD), provides a more consistent and relatively steady rate of return – especially when contrasted to the stocks during periods of downside volatility.

Don't Miss Out!
Subscribe Today
to get our Special Feature Article
"Where to live in Retirement"

While California may be a sunny place to live or retire, its high income and sales tax rates, both near 10%, plus high housing prices can rain on anyone’s parade. Taxes reduce the purchasing power of your hard earned savings. This month (August 2009) we update a reader favorite “where to live in retirement” with links to the latest information to help make this important decision.