By Michael Brooks
Stockton, California, made headlines last June when it filed for a Chapter 9 bankruptcy. Now, a federal judge has not only given his okay to proceed; he’s also thrown retiree pension benefits into the debate. The big question is whether these benefits can be cut. The outcome could be a groundbreaking decision that would encourage other municipalities to adopt this approach—particularly those with pension problems.
Up to this point only a tiny number of municipalities have taken the expensive and arduous route of filing for Chapter 9 to relieve their financial pressures. Out of 90,000 government entities in the US, only 10 municipalities filed last year (as of October 1). Stockton is the most populous US city to have done so. There have been so few municipal bankruptcies over the years that the law is ill defined, which will magnify the impact of a precedent that allows a reduction in retiree pension benefits to be included in a bankruptcy solution.
Stockton hasn’t asked for relief from its pension costs, despite the fact that its pension provider (CalPERS) is the city’s largest creditor. Apparently Stockton prefers to lean more heavily on its unsecured bondholders—the city suspended debt service payments on several of its bonds. If the courts eventually allow pension benefits to be included, bondholders might not have to bear as much weight and might reduce their potential losses.
How can investors avoid bonds that could entangle them in such situations? One thing is for sure: it’s hard to argue that Stockton’s bankruptcy sneaked up on anybody. Stockton’s troubles had been well documented. The City Council had declared fiscal emergencies as early as 2008; unemployment was as high as 22%; and the median sales price of homes dropped from $422,000 in 2006 to just $140,000 in 2012. Issuers with problems as serious as Stockton’s are easy to identify and avoid with credit research.
But if another deep recession hits the nation, many municipalities could quickly find themselves in trouble. State and local governments are more vulnerable today than they were before the 2008 recession owing to reduced rainy-day funds, weaker pension funding, and constraints on actions that would let them cut spending and raise revenues even more than they have already done.
We believe it makes sense in this environment to significantly underweight state and local general obligation and related bonds. We see more safety and opportunity in essential-purpose revenue bonds in sectors such as water/sewer, public power, public transit, airports and public universities. These types of bonds are backed by specific cash flows and tend to be far more stable in economic downturns.
Even if an increasing number of municipalities were to choose the bankruptcy route, they would make up only a tiny fraction of bond issuers. We don’t think there’s much danger for investors who do their homework on municipalities.
Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.
Michael Brooks is a Senior Portfolio Manager, Municipal Investments, at AllianceBernstein.