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Why Municipal Bonds are Bad Investments

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Municipal Bonds Today.com is dedicated to helping investors demystified the municipal bond market place, so what better than to have an article describing reasons why municipal bonds are a bad investment.  We need to understand the dark side of municipal bond investing to realize areas we need to avoid.

Revenue Challenge

Revenue from sales tax, income tax, and property taxes are falling, so municipalities are encountering hard times and may default more often than the past. Towns and cities often rely on one fourth of their revenue from property taxes. One third of their revenue typically comes from state aid, according to the Congressional Budget Office. The credit crisis, unemployment, foreclosures, and the like are impacting the ability to meet obligations. Many local governments have major financial problems, and need to work out their problems without borrowing more money. Analyst Meredith Whitney explains the situation in this video. Stimulus funds run out in June 2011, so a day of reckoning is close at hand.

States have increasingly relied on issuing new debt to pay their bills, rather than increasing taxes or cutting spending.

Tobacco Issues

Tobacco bonds are backed by payments made to the state government by tobacco companies. These statements are based on projected cigarette sales. The problem is that cigarette consumption keeps dropping, making the original projections way out of whack. This leads to fears that defaults could occur.

Failed projects leads to bond Defaults

Revenue bonds on projects with an ample amount of risk are failing. Key examples of failed projects include Wisconsin‘s steam plants, Las Vegas monorail, and non-hospital healthcare facilities. If you go back and look at the Official Documents, you can see that there projections a.k.a. guesses were way off, and bond insurance has amounted to little insurance.

Underfunded Pension Liability

There are many states with massively underfunded pensions. These long-term liabilities are usually not on the balance sheet and hidden away from most investors. It is estimated that $11 trillion is the amount nationwide that is underfunded. But, 84% of state pensions were funded, in aggregate. This is a serious long-term issue that needs to get addressed. Official Statement‘s need to get beefed-up to acknowledge these liabilities. Municipalities have to raise taxes, increase retirement age, and cut services to bridge the pension liability gap. At least this liability is not a near term causer of default risk.

Additionally some states have underfunded Unemployment Funds.

No AAA Rated Insurers

Municipal bond insurance used to be incredibly important, but now that there are no more AAA-Rated insurance companies, fewer than 10% of bonds get insured. Credit ratings of the underlying security are much more important now.

City/State Budget Gaps

Many large states and cities are running huge budget gaps. Expenditures far exceed revenues, something that doesn’t work very long. $350 billion is the projected gap for 2010 and 2011. Illinois has a 42% gap, while California has a 22% gap. Something needs to be done to stop the hemorrhaging. The health of local governments usually lags the national economy by a year or two.

Desperate Municipalities Selling Assets

To plug huge deficits, municipalities are starting to sell off physical assets like real estate. Many cities are exploring selling buildings and then leasing them back. The key is to make sure that the lease service funds have been appropriated, or else a bigger hole will emerge for them.

Substandard Disclosure

There have been several cases of lawsuits against local governments claiming that the government misled investors when making a bond offering. New Jersey and San Diego, in 2010, got sued for failing to fully disclose their pension liability. The SEC is investigating the area and will hopefully add more disclosure requirements to municipal bonds. A municipal bond unit was set up by the SEC in 2010 tasked with ensuring that information was disclosed to bondholders in a timely fashion.

In the middle of 2012, the SEC asked Congress for the authority to fix the problems with municipalities who issue bonds but don’t keep the public up to date on their financial situation. They would like to allow intermediaries to sue the municipality when disclosures are breached.

Audited financial statements could be wrong. Municipal auditors engage in peer review process, something that was used during Enron’s era. Accounting standards differ in need to be standardized. Random Federal Audits in 2007 no problems relating to internal controls in many municipalities.

Investors must wait a year or more to see updated financial statements for cities, states, and others. By that time the financial condition may have changed drastically. A recent study showed that 56% of bond issues from 2005 through 2009 filed no financial statements in any given year. This means that more than $2 trillion of the $3 trillion in outstanding municipal bonds had insufficient ongoing disclosure.  There some instances where municipal bond investors have gotten little or no disclosure prior to a default.

Conduit Financing

Conduit Financing is where private or nonprofits use the municipal bond market for funding. The public issuer gets fees for helping the firm do it, but incurs no legal or financial liability. These are typically unrated municipal bonds that make up approximately 30% of the marketplace, but produce 35% of municipal bond defaults. Another Problem Is That the Government loses out of tax revenue.

Letters of credit

Does the state or local government have a letter of credit with a bank? When does it expire, how likely is it to be renewed by the bank. If a bank failed to renew letters of credit, then the municipal bond would need to be refinanced, causing problems.

Adjustable Rate debt

Some cities and towns in 2011 have been affected by the Greek debt crisis. They took part in municipal bond deals backed by Dexia, a Belgian French bank with large exposure to  Greek government debt. The bank had previously offered cheap financing by agreeing to backstop their municipal bonds, but the bank is now forced to increase the interest rate the cities pay, causing substantial problems.

Interest Rate Swaps

Does the state or local government have any interest rate swap agreements that they set up to try to limit interest rate risk? It is possible that interest rates will move against the swaps, causing possible problems.

Poor Regulatory Framework

The SEC can pursue violations of security law, regulate underwriters, and regulate sellers of municipal bonds. It can require them to demand financial disclosure from issuers. It cannot do this today to issuers directly. The Tower Amendment, adopted in 1975, forbids the SEC from requiring states or local governments to file information with it. This amendment arose to prevent Federal government from impinging on state sovereignty. Considering any major problem in the municipal bond market would eventually fall on the Federal government anyway, this law is out of date. The SEC can only go after broker dealers that commit fraud. Clearly the SEC’s power needs to be extended.

Bond Rating Agencies

Moody’s, the rating agency, has 120 people analyzing 29,000 issuers. Clearly they only can do so much work every day. The issuers need far more scrutiny on a continual basis. Also recall how many failing securities had AAA ratings right before the credit crisis.

Doomsday scenario

A default by a state or major municipality could have unforeseen effects to the credit markets.  It is possible that the ripple effect could cause another credit crisis.

Federal Reserve bailout

Keep in mind that the Federal Reserve is limited by law to only buying certain kinds of very short term Muni debt with maturities no more than six months, so bailouts are limited. They could possibly use emergency powers to buy longer maturity municipal bonds,  if there is enough political will.

State Bankruptcies

Currently, states cannot file for chapter 9 bankruptcy, making it difficult for states to terminate costly contracts, restructure bond debt, and to redo expensive Cadillac pension benefits promised to state workers. Some cities and counties can file for bankruptcy although 26 states prevented. Keep in mind that when municipalities file for bankruptcy, only elements like interest payments can see some relief, making it not a foolproof way to solve larger problems.

Related Municipal Bond articles:

Analyzing Municipal Bond Defaults

Are we in a bond bubble?

Municipal Bonds are Bad Investments

Municipal Bonds Are a Good Investment

Education Individual Bond Municipal Bond Mutual Fund

The Risks of Owning Municipal Bonds

municipal bonds

The bond markets are an excellent place for most investors to invest capital and generate consistent returns.  Like any capital market, bonds are not without risks.  For municipal bonds, investors need to concern themselves with inflation, defaults, ratings downgrades, material events, liquidity issues, budget woes, spending cuts, and unfunded pensions and unemployment funds.  Each of these issues can erode the value of municipal bonds.  Since bond prices fluctuate on a daily basis, it is important to become aware of few factors.

The primary risks in municipal bond investing:

  • Income Risk – The problem caused by reduced income from bonds due to falling interest rates.
  • Interest Rate Risk – When bond prices decline due to rising interest rates.
  • Call Risk – In periods of falling interest rates, bonds with a Callable option may be redeemed before they mature, reducing price appreciation potential.
  • Credit Risk – If a bond issuer has financial problems, a credit rating agency may downgrade the bond, causing its value to decrease.
  • Liquidity Risk – If markets are in turmoil, their is a chance that no one will want to purchase a security.
  • Manager Risk – The mutual fund manager may select risky investments that cause under performance.

Inflation:

Inflation is a rise in the prices of goods and services over a period.  Inflation is also erosion in the purchasing power of money.  With everything remaining the same, an increase in prices, hurts a consumer’s ability to purchase goods and services.  In general, inflation is measure by a basket of goods.  The recognized gauge of inflation is the consumer price index.

Since municipal bonds are fixed income products, when inflation moves higher, the real purchasing power of money (or fixed income) is reduced.  Therefore, when inflation ticks higher, bond investors generally reduce the amount they are willing to pay for a given bond, and demand more interest.

Investors can follow some general rules of thumb as it relates to bond prices, interest rates and inflation.

Price       Duration   Change in Rates      Change in Price     New Price

$100       10 years             1%                  -10%                        $90

$100        4 Years             1%                    -4%                         $96

$100        3 Months          1%                  -0.25                         $99.75

The average duration of a municipal bond is an important attribute to look at, when purchasing a bond. It is a measure of a bond sensitivity to changes in interest rates. The greater the average duration of a bond, the more its share price will fluctuate when interest rates change. If a bond’s average duration is 2.5 years, a 1 percentage point rise in interest rates would lead to an estimated 2.5% decline in the share price. A 1 percentage point decline in rates would likely lead to a 2.5% rise. Increase your duration if you think interest rates will fall or deflation will occur. Reduce your duration if you believe interest rates are rising and inflation is occurring. In a rising interest rate environment, investors may want to hold bond with shorter durations of around 2-4 years.

There have been a number of articles recently written about the perils of owning municipal bonds.  A recent article in the Wall Street Journal compared issues that the municipal bond market is facing to issues faced in the housing markets to sub price debt.  The article mentions that the greatest default risk is in small municipalities with over leveraged projects buffeted by the recession. Those places also might need to access credit markets less in the future than big cities, making it easier to walk away from their debt than paying you back.

Monitoring the news and determining the effect on your portfolio is important for active bond investors.  A passive investor still needs monitor markets movements since about 96% of Muni bonds experience credit rating changes within a 10 year period.

Downgrades and Super Downgrades

Bonds are only reviewed periodically by the big ratings agencies, so there is a chance the credit worthiness has slipped between evaluations.  This can lead to super downgrades where the bond is lowered in quality several notches at once.  A bond’s value would probably slip when this occurs. Some fund managers maybe forced to sell the bond due to its lower quality.

How defaults affect bonds

The municipal bond sector has had a solid record of accomplishment when it comes to the magnitude and frequency of defaults.  Defaults are times when a municipality cannot pay its debts and misses a payment or seeks bankruptcy protection.  Currently, states cannot file for chapter 9 bankruptcy. Some cities and counties can file for bankruptcy although 26 states prevented. Municipal bonds are considered the second safest category following securities issued by the Federal Government.  In the event of a default, bondholders seldom lose their entire principal. Often, a default could result in the suspension of the coupon payment, or a delayed payment.  California General Obligation bonds are second in line for payment, just after education.

While cities can and do file for bankruptcy, they are unable to liquidate or be forced to repay debts like a company. Oftentimes municipal bankruptcies take years to become resolved. In the meantime debt repayment is put on hold.

Municipalities or projects that produce late financial statements are more likely to default. Look for bonds with material events or ME flags as warning signs. Unfortunately material event notifications can occur months after the event, and there is no consequence for failing to report material events. And enforcement system should exist. You can look up material events for a specific bond on msrb.org by entering its CUSIP number and clicking on Continuing disclosureMaterial event notices. Also use the EMMA System Alerts feature to stay up to date on any important disclosures.

History of Defaults:

Default rates, varied significantly across municipal sub-sectors, even though the overall rate was low compared too many fixed-income sectors. A study perform by Fitch study found that the 16 to 23 year cumulative default rates for tax-backed and traditional revenue bonds were less than 0.25 percent. Industrial revenue bonds had a cumulative default rate of 14.62 percent, multi-family housing 5.72 percent, and non-hospital related healthcare 17.03 percent. These three sectors accounted for 8 percent of all bonds issued but 56 percent of defaults. Education and general-purpose sector bonds accounted for 46 percent of issuance but only 13 percent of defaults.

One of the new findings in the 2003 study was that there was a moderate correlation of default risk with economic cycles, though a one-year lag produced a higher correlation. During the early 1980s and the early 1990s when economic growth was slow, default rates were the highest.

A December, 2010 report from Bank of America Merrill Lynch indicated that there was $4.25 billion of municipal debt in default, representing only 0.15% of the entire municipal bond market.

Another new finding was that defaulted municipal bonds have a high recovery rate of 68.33 percent based on the number of defaults. Recovery can be made in a couple of ways. The borrower may get out of the default situation by making full debt service payments or forfeiting collateral securing the bonds may be liquidated. Most issuers, particularly providers of essential services such as water and sewer, eventually resume paying debt service.  Make sure that not just a handful of customers are paying for the essential services. They are never pledged to bondholders. In such cases, bondholders maintain a lien on revenues, which often enables full recovery. Industrial development bonds and multifamily housing bonds, the two sectors with the highest default rates, are often backed by collateral leading to higher than average recovery rates.

Read:

Analyzing Municipal Bond Defaults for additional information.

Bond insurers

The key to successful municipal bond investing is to perform the due diligence needed to find a solid investment.  It is no different than finding a solid stock.  Prior to the recent credit crises, municipalities could purchase insurance for bonds, but AAA insurers no longer exist today, to back up bonds.

Recently in 2010, bond insurer Ambac moved into Chapter 11 and is no longer rated by credit reporting agencies, because it believes the IRS would gut the entire company. Municipal bond insurer FGIC is also in Chapter 11. Assured Guaranty is also having financial difficulty, their rating has fallen to a AA- as of 2012. MBIA has fallen to a B- rating, which is below investment grade. Their subsidiary National Public Finance Corp. is rated BBB. Because the number of insured Muni’s has fallen to about 7%, the municipal bond market has become more fragmented with 20,000+ bond issues needing to be carefully scrutinized for risk. There are now very few mutual funds that predominately hold insured municipal bonds, due to their scarcity.

Recent problems in the industry include some shortfalls of full disclosure.  An example in 2010 was San Diego failed to disclose underfunding pensions in bond offering disclosures (penalties were paid by San Diego).  The SEC may impose more penalties or require more disclosure, as there is not enough money to repay bondholders if failure occurs.

State Budget Problems

Sometimes the volatile stock market causes problems for state budget planners. The assumptions they have made in regards to personal income tax collection are heavily affected by stock market returns and taxes collected from wealthy individuals. State budget prospects may become more gloomy due to a declining stock market, forcing states to pare back on their budgets.

Additional Related Municipal Bond Educational Articles:

What are municipal bonds?
How to Research Municipal Bonds
The Risks of Owning Municipal Bonds
How to Buy And Sell Municipal Bonds
Municipal Bond Mutual funds – Municipal Bond Managed Accounts
What Are Closed-end Municipal Bond Funds?

What are Municipal Bond Exchange Traded Funds or ETFs
How to Make a Municipal Bond Ladder
How to Select Municipal Bonds
Municipal Bond Trading Example
How to Perform Active Municipal Bond Management
Municipal Bond Books and Educational Resources

Education Individual Bond Mutual Fund

Analyzing Historical Municipal Bond Defaults

municipal bond quotes

Municipal bond owners worry about their bonds defaulting. When a bond defaults, interest payments get interrupted and you may never see return of principal.  It is prudent to understand the past to avoid future problems. An average of eight municipalities defaults occur every year, although more will probably start to appear in 2011.

Great Depression

One of the worst periods in the markets history, the Great Depression saw its worst year in bonds in 1935. 1.8% of issuers were in default. Interest or principal payments were late or missing 1.7% of the time from 1929 to 1937. Only 0.5% of the interest or principal payments were still lost by 1937. The average default rate was 97%. From 1929 to 1939 the pretax annualized return on municipal bonds was a very good 5.1%. Some argue that municipalities were in better shape before the Great Depression then they were during the Credit Crisis.

1841 Defaults

In 1841, a depression occurred and nine states defaulted on their debts. Most of the states eventually paid off their debts, but Mississippi still has not. Laws were changed to increase safeguards after this situation, and new borrowing was clamped down upon. Congress in 1843 rejected a bailout plan, worried that were caused recklessness and extravagance among states. Taxes were increased significantly to pay for infrastructure and meat debts. Indiana and Ohio soft property taxes go up eightfold. Yield’s on state bonds increased from 12% to almost 30% by 1842. It is clear that government needs taxpayers to approve tax increases as a direct result of making new loans. It is currently harder to raise taxes meant to raise expenditures.

Municipal Bond Default Rates

Analysis from Moody’s Investors Service indicates that the default rate from 1972 to 2009 is 11.1% for corporate bonds, 0% for AAA municipal bonds, 0.03% for AA-rated municipal bonds, 0.03% for A rated municipal bonds, and 0.16% for Baa space rated bonds. The default rate was 3.4% for lower rated bonds. Unrated bonds have a higher default rate. Clearly the default rate will rise after the credit crisis, possibly to the 1 to 2% range.

A December, 2010 report from Bank of America Merrill Lynch indicated that there was $4.25 billion of municipal debt in default, representing only 0.15% of the entire municipal bond market. For 2010, new municipal bond defaults amounted to $2.7 billion or about 0.09% of outstanding issues. Nearly all the defaults were for unrated bonds.

Unrated and Non-Investment Quality Bonds

Many of the municipal bond defaults occurred in so-called unrated municipal bonds and non-investment quality municipal bonds. Obviously avoiding this area is recommended. Investors are attracted by the high interest rates these municipal bonds yield. Remember the bond portfolio should be one of the safest parts of your portfolio. Municipal debt backed by appropriation pledges is equivalent to an unsecured creditor.

Chapter 9 Municipality Bankruptcy

If a municipality is financially troubled or simply runs out of money, they can declare Chapter 9. The bankruptcy law is hazy on how far a municipality can go in re-architecting pensions for current retirees. Bondholders are not insulated from loss. 26 states do not allow their municipalities to file bankruptcy. In other areas, the city must demonstrate that it is technically insolvent. Chapter 9 remains a largely untested area of the bankruptcy code. Unfortunately it will probably yet tested heavily in 2011 as municipalities fail. States cannot file for bankruptcy.

In 2009, ten municipalities filed bankruptcy. In 2010 the number was five. Since 1930, 600 cases of bankruptcy have arisen. More municipalities in the near future may file for bankruptcy due to the Credit Crisis of 2008. With bankruptcy, legal and consulting fees will cost municipalities great deal of money.

Since 1981, of 43 municipal bankruptcy, 33 were dismissed by the judge when trying to discharge their debt, and the remaining 10 did not list the final outcome but none had the principle owed reduced. The 2008 Vallejo bankruptcy was the first that sought to cut the interest rate paid to its lenders.

Riskier projects

Some of the projects that have the most defaults include: nursing homes, long-term care facilities, apartment buildings, toll roads, museums, stadiums, real estate developments, land, housing, not for profit hospitals, and high risk real estate.  According to Moody’s of 54 defaults from 1972 to 2009, 78% were in standalone housing and healthcare.

Of the defaults on municipal bonds rated by Moody’s from 1972 – 2009, here is the breakdown:

  • 21 in housing
  • 21 in health care
  • 4 City, town, county non-general obligation
  • 3 electrical, water, or sewer utility
  • 3 general obligation
  • 1 higher education
  • 1 recreation

Municipal bond areas with the highest default rates are Community-Development districts, assisted living, independent living, nursing homes, and telecom.

Late Financial Statements

Municipalities or projects that produce late financial statements are more likely to default. Look for bonds with material events or ME flags as warning signs. Unfortunately material event notifications can occur months after the event, and there is no consequence for failing to report material events. And enforcement system should exist. You can look up material events for a specific bond on msrb.org by entering its CUSIP number and clicking on Continuing disclosureMaterial event notices.

Tobacco Bonds

Tobacco bonds are backed by payments made to the state government by tobacco companies. These statements are based on projected cigarette sales. The problem is that cigarette consumption keeps dropping, making the original projections way out of whack. This leads to fears that defaults could occur.

On November 11, 2010, Standard & Poor’s downgraded $22 billion of tobacco bonds to junk status, mainly those with lower coverage levels that make them more susceptible to declines in smoking. This led to a significant yield rise in municipal bonds and a fall in prices.

Las Vegas monorail

Las Vegas monorail is a high profile project that has run into problems due to poor revenue. Even though the bonds were insured, insurance company is having trouble itself to just stay afloat.

Vallejo, California

Vallejo is a city about 30 min. north of San Francisco, which had outstanding debt, and declared Chapter 9 bankruptcy in May 2008. This is the second largest municipal bankruptcy filing in California. The police and fire unions salary and benefits took up roughly 80% of the city’s budget. The city owes more than $50 million and has just $5 million to pay them back. Vallejo Municipal bonds have been on hold while the city works out a restructuring plan.

Right now it looks like no interest would accrue through 2013, and general fund principal and interest payments would be suspended through 2013, although more pain may occur. Most original holders of insured Vallejo municipal bonds have been paid in full or will be. Owners of water or sewer revenue bonds are entitled to payments under bankruptcy law provisions.  As long as revenue continues to be collected. General obligation and other bond holders may not be paid in full.

The city, California state controller, and the bond insurer, agreed that in event of default, the insurer could access some of the funds that California distributes local governments.  This is significant because it upholds the right to access to money that helps backstop many municipal bonds.

The city did not reduce pension payouts for current retirees, only new employees, in its reorganization, although it did propose trimming workers and retirees health care benefits. This goes to show that expensive contracts and pension benefits do not necessarily get trimmed in Chapter 9. Often times lawyers are the ones that make out in the end of any long battle. Vallejo did uphold its bankruptcy right to reject collective-bargaining agreements with unions in a 2009 court decision.

Stockton, California

Stockton, California declared Chapter 9 Bankrupcy on Thursday, June 28, 2012. The biggest city in America to file bankrupcy is now Stockton. Their problems were caused by the forclosure crisis, expensive retiree benefits, and millions spent on civic improvement projects. They have tried to make ends meet by slashing their budget, laying off police and other city employees. All payments were suspended to bond holders and other holders of long term debt. They have nearly $1 billion in long term debt.

Orange County, California

Orange County, California declared bankruptcy in 1994. Roughly $2 billion was owed. Investors eventually were made whole on Orange County bonds, although county taxpayers will continue to pay off their refinanced IOUs for two more decades.

Menasha, Wisconsin Steam Plant

Wisconsin‘s steam plants that issued municipal bonds are in trouble and the city is trying to walk away from its obligations. This is another case of a risky project dependent on the new plant and specific customers.

Harrisburg, Pennsylvania

Harrisburg filed for Chapter 9 Bankruptcy Protection in Oct. 2011. They were saddled with a huge $400 million debt tied to a trash burning incinerator. Bond holders and the city could not negotiate a settlement to avoid bankruptcy. There have been 48 bankruptcies from cities, counties, and towns since 1980.

Jefferson County, Alabama

Jefferson County, Alabama filed for bankruptcy in November 2011 with $3 billion of debt. Their major problem was a failed sewer deal. This is the largest municipal bankruptcy yet. Their exotic refinancing deals with large Wall Street banks backfired and resulted in 20 Alabama officials, contractors, and others to be convicted of fraud.

Related Municipal Bond articles:

Analyzing Municipal Bond Defaults

Are we in a bond bubble?

Municipal Bonds are Bad Investments

Municipal Bonds Are a Good Investment

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