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Saturday, August 08, 2009

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.

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