Opinions Investor's Corner John Gudritz's Investor’s Corner - Overblown concerns of municipal bonds
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Investor’s CornerBy John Gudritz CFA
Principal
Front Street Investment Management LLC
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While investors in the $2.9 trillion municipal bond market have been concerned over the past year about the growing budget problems faced by most state and local governments, most of them were stunned by a dire forecast made by an influential Wall Street analyst in December. That alarming forecast has caused interest rates on these bonds to jump to levels not seen since the debt crises in 2008 and for $25 billion to be pulled out of municipal bond funds in two months. In my opinion, the combination of inflation worries and overly pessimistic credit concerns have actually provided a wonderful buying opportunity for good quality tax-free bonds.
Meredith Whitney, who runs her own firm, Meredith Whitney Advisory Group LLC, made a name for herself in the 2008 financial crises for warning the investment community about the severe problems facing the banking industry and particular banks like Citigroup. Her analysis was spot-on in most cases, and she prevented many investors who listened to her from investing in bank stocks before many of them had bottomed at much lower prices.
Last year she decided to look into the municipal bond market and released a study in December that has scared many investors out of these bonds. Meredith announced to the world on television programs like 60 Minutes and cable networks like CNBC and Fox Business that their analysis showed that “50 to 100 municipal bond issuers representing hundreds of billions of dollars of debt could default or restructure in 2011.”
Needless to say, this prognostication came at a time when the news is full of stories of states and local governments searching for ways to raise revenues and cut spending to close the budget gaps. It is no wonder that many investors would be inclined to sell their bonds first and ask questions later.
However, based on the closer examination of the facts, including Meredith’s own report, her forecast looks a little dramatic and based on a very worse case scenario.
While it is true that states are facing significant budget shortfalls this year, debt service is not the problem. A report issued by Fitch Ratings last November said that, “debt service is generally less than 10 percent of a state or local government’s budget, and in many cases much less.” According to Census Bureau data, interest payments on state and local bonds generally absorb only 4-5 percent of current spending. That is no more than they did in the late 1970s. If a state or local government is in fiscal trouble, reneging on their debt obligations is not really going to solve their budgetary problems and would create severe financing problems in the future.
Municipal bond defaults have been extremely rare historically. According to Moody’s Investors Service, there have been 54 defaults of 18,400 rated municipal bonds between 1970 and 2009. Moody’s, Standard & Poor’s and Fitch put the default rate at less than one-third of 1 percent.
History shows that the vast majority of municipal bond defaults have been corporate or nonprofit borrowings using a municipal conduit such as nursing homes and housing developments to qualify for tax-free financing. Over the past 40 years there have been only four defaults that were bonds that were obligations of cities or counties.
The big challenge for state and local governments over the next decade will be addressing the current underfunding of pension plans and rising healthcare costs for current and retired employees. These pension plans were fully funded on average as of the year 2000. Today they are about 20 percent under-funded due to poor investment results and cuts in contributions to the plans. The healthcare benefits and pension plans for younger current employees will have to change in many cases.
With the improving economy, revenues for the states and local communities have been increasing since 2009. Unfortunately, with the continued high rate of foreclosures and short sales, it is not likely that property taxes will be increasing any time soon. While some states like Illinois will be raising taxes, most states like New Jersey will continue to focus on spending cuts to fill the deficits and balance the budgets.
Despite these challenges and the probable rise in the number of municipal bond defaults in 2011, I think the current credit concerns in the municipal bond market are overblown. The good news is they are providing a great buying opportunity for good quality general obligation bonds and essential service revenue bonds.
John W. Gudritz CFA, is a principal at Front Street Investment Management LLC, a fee-only investment management firm in Traverse City. Reach him at 866-933-7668 or visit www.frontstreet.com.