It is no secret that governments at all levels - state, Federal and local - are facing dire financial problems. However, they are dealing with those problems in different ways. Despite towering budget deficits, the Federal government is spending merrily away and covering the deficit by just issuing more debt, so far without a hitch. States cannot run a deficit from one year to the next, so some are using a variety of gimmicks to paper over the deficit.
In many ways, the distress seems to be most acute at the local level and municipal bankruptcy is now a hot topic. This Bloomberg piece, Bankruptcy Bloodbath May Hit Muni Owners (Bloomberg, Feb. 10, 2010, Joe Mysak), gives some detail on what is happening [emphasis added]:
…The biggest financial crisis since the Great Depression is squeezing municipalities across the country. Since Vallejo, California, successfully petitioned for bankruptcy protection in May 2008, California’s towns, Detroit’s schools and Pennsylvania’s capital city of Harrisburg have all talked about Chapter 9.
That should make bondholders nervous because it “questions whether a local government’s labor contracts would be surgically undone with bondholders’ rights left intact,” Fitch said.
Or as John H. Knox, a partner with Orrick, Herrington & Sutcliffe in San Francisco, which is counsel to Vallejo in its bankruptcy, said in an interview: “Any plan is going to impair all classes of creditors, including bondholders.”
Vallejo, a city of 117,000 on San Francisco Bay, wants to roll back salary and benefits, cut services — and reduce debt payments. “No interest would accrue for four years, and general fund principal and interest payments would be suspended for three years,” the city’s workout plan states.
This might save the municipality, or, depending upon your point of view, cost investors, $13.4 million.
…Stiffing bondholders, even a little bit, would be unusual in the tax-exempt market, said James E. Spiotto, a partner at Chapman & Cutler in Chicago and a municipal bankruptcy specialist. That’s because most municipalities don’t go out of business in bankruptcy and need ready access to the credit market in order to borrow money. Reducing interest rates and extending repayment terms to bondholders are the usual strategies…
Most of the muni bonds that have had problems are special purpose bonds, such as bonds that have financed a large waste incinerator in one case. The case of Vallejo, CA is unusual in that the bankruptcy was not for a special project, but for the city.
For investors seeking tax exempt income, this is a time to be careful. In particular, I recommend that you avoid the highest yielding muni bonds and bond funds. The reason for investing in income is not, in my opinion, to get the highest return, but rather to get a solid return with modest risk.
Another important point is to consider diversification across state lines. Many investors prefer bonds or bond funds from their state of residence, mainly for tax reasons. However, there is less diversification in a state specific fund.
Disclosure: No positions