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Earlier this month, Jefferson County, Alabama, became the largest issuer in the municipal bond market to file for bankruptcy. Back in 1997 the county tried to upgrade its sewer system. Through losses on interest rate swaps and fraud, the debt burden from the sewer project rose from $555 million to more than $2.2 billion. After spending years trying to find a way out of the mess, the county finally filed for bankruptcy on November 9.

Jefferson’s filing has raised a number of questions among investors, including what will happen to Jefferson County’s debt?

Well, Jefferson Country has a few different types of debt in the market including $200 million of general obligation bonds, $3.1 billion of revenue bonds tied to the sewer system and $930 million in other bonds, like school bonds. These bonds will be restructured as a part of the bankruptcy process.

The revenue bonds tied to the sewer system were downgraded to junk status in February 2008, so they were already trading at distressed levels. It’s still too early to tell what holders of these bonds might be paid, however we can look at where these bonds are currently trading to get an idea where market participants are estimating their value. Let’s look at a Jefferson County bond that matures in 2016 with a 5.25% coupon. At November 17’s price of $80, the market expects a recovery rate of around 80 cents per dollar of par value.

Jefferson County also has some debt that is escrowed and fully backed by U.S. Treasuries. These bonds did not get downgraded with the rest of the debt in 2008 and they currently carry a AAA-rating by Moody’s, which is in-line with the Moody’s U.S. Treasury rating. These bonds do not carry credit risk as there are Treasuries held in account that will be used to repay bondholders. However, due to the headline risk surrounding Jefferson Country even these bonds have experienced price declines.

But the bigger question circulating among investors - given that there has already been a heightened sense of concern about muni credit risk in the market - is could this bankruptcy be a sign that we will see defaults from other issuers?

First, keep in mind is that this story has been developing for years, and the bankruptcy filing is not an unexpected event. Investors who hold Jefferson Country bonds should seek professional advice on whether their bonds were impacted and what the right course of action is.

On the iShares side, none of our municipal bond ETFs held Jefferson Country debt. If you want to see what the funds do hold, holdings for all of the funds are published every day on iShares.com.

Municipal bond investors should continue to be aware that municipal bonds do carry credit risk, and should look for strategies that help manage that risk. That said, I do not believe that the Jefferson County bankruptcy filling will signal a wave of municipal defaults. This is a unique situation, one driven more by fraud and poor deal structure than by the economic environment. It is unlikely that there will be any broad impact on the municipal bond market.

Click to enlarge

Source: BlackRock, Citigroup and Bloomberg.

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Past performance is not indicative of future results.

Bonds and bond funds will decrease in value as interest rates rise. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.

Source: Municipal Debt: Did My Bonds Go Down The Sewer?