Municipal Bonds Experiencing ‘Rough Ride’

April 5, 2012 Updated: April 5, 2012

Recent media publications warn of municipal bond defaults. Headlines of March articles on the Profit Confidential website suggest that “U.S. Municipalities [are] Falling Like Dominoes,” and “Municipal Bond Defaults Doubling; Bailout Options Diminishing.”

The Insurance Journal reported that 21 municipalities defaulted so far in 2012, compared to 28 for the entire year of 2011, stating, “A growing number of U.S. cities are choosing to fund essential services like public safety and garbage collection over making payments on their outstanding debt, as rising costs and falling revenue deplete their budgets.”

Morgan Stanley Smith Barney wrote in its March 16 Municipal Bond Monthly, “The municipal bond market has had a rough ride since our last edition,” suggesting again that there are major problems in the municipal bond market.

Although a list of 2012 municipality defaults is not available, the media reported that as of March, municipality defaults totaled $978 million, while the 2011 defaults amounted to $522 million.

In early March, Harrisburg, Pa., missed its payment on bonds worth $5.3 million for the first time. Ambac Assurance Corp., the city’s insurer on the bonds, is supposed to cover the payment on behalf of Harrisburg, according to Moody’s and a number of media reports.

At the end of February, the city council of Stockton, Calif., held off paying $2 million in bond payments. Wells Fargo & Co. filed a lawsuit against Stockton for defaulting on its Feb. 28 payment, according to the Insurance Journal website.

Wells Fargo and other creditors of Stockton reached an agreement to assist Stockton in its efforts to avoid filing for bankruptcy, according to the Law360 website.

“Stockton, buckling under the weight of retiree health insurance obligations, large bond sales, big labor contracts, loss of revenue and poor financial practices, is taking advantage of a new California law that lets municipalities in financial distress confidentially mediate with creditors or ‘interested parties,'” according to a March 22 entry on the Law360 website.

On Feb. 1, the city of Hercules, Ca., skipped its interest payment on a $2.4 million bond. The city, just like Harrisburg, Pa., is insured by Ambac Assurance Corp. Although Ambac most likely will front the Harrisburg payment, it sued the Hercules Redevelopment Agency (HRD) for whatever cash the city had in its coffers and/or requested a lien on the city’s assets, as Hercules agreed to guarantee the bond repayment, according to several websites.

On March 10, media reports indicated that Hercules and its debtors are negotiating an equitable solution to stave off the city filing for bankruptcy protection.

The problem was that “the cash-strapped city currently would have little to put up other than perhaps some real estate it owns, much of which is currently for sale,” according to the insurancenewsnet website.

No Checkered Past for Municipal Bonds
“The number of municipal defaults increased since the recession, with 11 defaults on long-term bonds rated by Moody’s in 2010 and 2011, averaging 5.5 defaults per year compared with an average of 1.5 annual defaults over the period 1970–2009. Default rates for rated municipal bonds remain very low, with only 71 defaults over the period 1970–2011,” said Moody’s Investors Service in a recently released study.

Moody’s reviewed municipal bond defaults over a period of 41 years. During that period only five general obligation (GO) municipality bond issuers defaulted, and only one GO out of about 9,700 rated municipalities defaulted between 2009 and 2011.

A GO bond is a U.S. municipal bond for which a state or local government provides a guarantee. In the case of a municipality default, the guarantors will repay the obligation to bondholders with funds from different sources, such as property tax revenues.

“GO bonds are normally sold to fund ‘brick and mortar’ capital improvement projects such as roads, parks, or schools,” Moody’s said.

Most defaults that occurred during the 41 years were in the housing sector (40.8 percent with 29 defaults) and in the hospital and health service sector (32.4 percent with 23 defaults). All other sectors, including education, infrastructure, utilities, and water and sewer, had fewer than 5 defaults each.

“Of the bonds that did default, the major cause, according to Moody’s, was ‘enterprise risk.’ This risk results from a failure of a bond-financed project to achieve its projected results due to faulty planning or economic downturn, rendering a project unfeasible,” according to a March 22 article on the fmsbonds, Inc. website.

The average municipal bond recovery rate of defaulted amounts for the years 1970 to 2011 was 65 percent, 16 percent higher than the recovery rate for corporate senior unsecured bonds from 1987 to 2010.

Municipal bankruptcy filings are highly infrequent given political and legal stumbling blocks. Generally, bankruptcies only occur when state or local government guarantees are withdrawn, or the guarantor had payment problems and had to use its funds for other purposes.

Defaults by municipalities will subside as the economy improves and municipalities’ property tax collections increase. Secondly, defaults jeopardize borrowing opportunities in the market and result in higher interest rates, motivating municipalities to default only as a last resort.

“Unlike corporates and sovereigns, only a small portion of rated municipalities have refinancing risks, and debt service typically represents a low percentage of municipal expenditures, so municipal issuers have little to gain by defaulting,” said Moody’s in its study.

“We expect municipal debt defaults will remain infrequent and isolated events, rather than systemic events, despite unprecedented credit pressure,” Moody’s said.

Strategic Investment
“The classic strategic reasons to own municipal bonds still hold true: They generally have low correlations to other asset classes and offer a meaningful tax advantage to investors—features that are unlikely to change in the near term,” suggests a newsletter on the Putnam Investments website.

Putnam implies that investors are better off buying a 30-year AAA municipal bond versus a pre-tax 30-year Treasury bond. First of all, earnings on municipal bonds are higher and secondly, they are tax-free.

Changes in the municipal bond market have precipitated a change in the bond insurance market. Putman suggests that most municipal bond insurance companies have disappeared over the years and municipal ratings were downgraded over the past few years by firms such as Moody’s, Fitch Ratings, and Standard & Poor’s. Also, it has become more difficult for municipalities to be granted a local or state guarantee.

“Almost all municipal bond insurance companies are on the brink of collapse except Assured Guaranty,” according to a Feb. 15, 2011, article on the bondview website.

Municipal bond insurance was not and most of the time is not of much value to the investor because investors buy more risky bonds as they pay higher dividends. Generally, the insurer only provides insurance to single-A rated bonds, that is, the insurance comes with the bond and is not bought by the investor.

“We believe bond insurance had very little impact on historical default statistics; the insurers generally provided credit enhancement for single-A deals and not for those at the low end of the rating spectrum, which are more prone to default,” the Putnam newsletter said.