“Is the town I live in going to go bankrupt?”

Normally this isn’t something that comes up in every-day conversation, but with a rash of municipal bankruptcies recently, it may be something that crosses our mind now.  The list of cities and/or counties that have filed for bankruptcy or look to be on the brink of doing so continues to grow every week:  Jefferson County AL, Central Falls RI, Harrisburg PA, Stockton CA, Detroit MI.  The media loves to report negative news and there seems to be plenty of it these days…..but what is the real story behind the headlines?  I’d like to offer a short write-up of the issues and explain why we shouldn’t be as worried as the media would lead us to believe.

First of all, what is a municipal bankruptcy?  Chapter 9 of the United States Bankruptcy Code is available exclusively to municipalities and aids them in the restructuring of their debts.  Bankruptcy is the end of the road for municipalities….liabilities are dissolved or restructured.  However, it is very difficult for a municipality to reach this stage.  They must meet certain conditions and be specifically authorized to be a debtor by state law or by a governmental officer.  Examples of municipal bankruptcies include Orange County CA in 1994, Vallejo CA in 2008 and most recently, Jefferson County AL in 2011.

So, what is a bond default?  A bond default is the failure to make timely payment of principal and interest or to fulfill other features of a bond’s indentures.  Even if a bond defaults, it remains a binding legal obligation between the issuer and those who own the security.  Examples of recent bond defaults include Harrisburg PA, which defaulted on $5.3 million of debt payments in March 2012.

The important thing to remember is that bankruptcy and default are not synonymous.  Bankruptcy does not always result in a default (i.e. liabilities can be restructured so that bond payments are still made), while default does not always lead to bankruptcy.

Now that we understand the worst-case scenarios, what does this mean in the world of bonds?  While defaults and bankruptcies by local governments have become more frequent recently, we must remember that historically municipal bonds are still very safe instruments:

  • From 1970 – 2009, there were an average of 2.7 annual defaults
  • For 2010 – 2011, that number jumped to 5.5 defaults per year

(source: Moody’s Munimonitor, March 2012)

 

This means that since the 1970s, municipal bond defaults overall have been at rates of less than 0.4%!!

And if we break down the defaults even further, we find that the majority of these defaults have been in “riskier” classes of municipal debt:

  • multi-family housing (1.6% default rate)
  • nursing homes and assisted living (4.5% default rate)
  • land-backed community development districts (16.5% default rate)

Traditional municipal bonds have much lower default rates:

  • general obligation debt (0.01% default rate)
  • “essential revenue” services such as water and sewer (0.02% default rate)

So even though the municipalities that are currently considering bankruptcy may increase these statistics slightly, we believe that municipal debt defaults and bankruptcies will remain occasional and isolated events.  We expect the vast majority of municipal issuers to continue to pay their debts.  The ones that do not pay their debt often have underlying issues that have been apparent for years (i.e. Stockton CA with record-high murder rates, unsustainable pension and health-care costs, the country’s 6th highest unemployment rate and 2nd highest foreclosure rate in the nation).

 

What can you do to protect your municipal bond holdings from bankruptcy and default?

  • First of all, buy bonds that are rated by at least one of the national credit rating agencies (Moody’s, S&P, Fitch).
    • According to MMA (Municipal Market Advisors), rated municipal securities have an especially low default rate….only 15 out of 25,000 rated issues defaulted in the period from 7/1/09 through 1/31/11
    • At Charter Trust Company, we go one step further, by employing our own internal rating methodology to any lower-rated credit
  • Understand the bond that you are purchasing.
    • If you don’t understand where the coupon payments are coming from, don’t buy it.
  • Stick to lower-risk, traditional municipal bonds (such as general obligation and essential revenue bonds) for the majority of your holdings.
    • The greatest risks lie in securities with high private participation, securities to fund real-estate development, securities from start-up or rapidly-expanding projects, or bonds with annual appropriation for non-essential projects (such as a sports arena or recreational area)