Investing in Municipal Bonds: Safe or Sorry?

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Includes: TFI, TLT
by: Michael Panzner

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(Source: Yahoo! Finance)

Spurred on by relatively high yields and a desire for "safe" investments, Americans have piled into municipal bonds. As a result, bonds issued by state and local governments have outperformed Treasurys by a hefty margin.

Unfortunately, investors seem to be ignoring the fact that many municipalities are in dire straits, hurt by falling tax revenues and rising costs, which means they may not be able to pay off their various obligations on time or in full. In fact, as Bloomberg/BusinessWeek columist Joe Mysak writes in "Bankruptcy Bloodbath May Hit Muni Bond Owners Next," a growing number are weighing an option that could lead to major losses for holders of these supposedly "safe" investments:

Public officials shouldn’t think about filing for Chapter 9 municipal bankruptcy to solve mounting labor costs and pension liabilities.

Even talking about this action will invite an inquiry from Fitch Ratings, the company said in a report published Jan. 27.

“The more bankruptcy is publicly discussed as an option for financial relief, the more its tarnish wears off, increasing the likelihood of its actual use,” Fitch said.

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.”

Share Losses

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.

Fitch is concerned that if Vallejo’s plan is approved, it may set a precedent. “At least some classes of bondholders must share in losses along with other creditors,” the rating company’s statement said.

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.

Hard Choices

Investors have long taken for granted municipalities’ ability and willingness to make bond payments. More Chapter 9 bankruptcies might force buyers to cast aside such assumptions. Public officials’ capacity to make unpopular decisions might become as important as the state of a community’s finances.

Local governments have been reluctant to reduce headcount during the recession...

“In most states, labor laws applicable to public employee contracts place numerous restrictions on revising labor agreements, even if the agreements are pushing the municipality toward bankruptcy,” Orrick’s Knox and colleague Marc Levinson wrote in “Municipal Bankruptcy: Avoiding and Using Chapter 9 in Times of Fiscal Stress,” a booklet published in 2009. “However, if all parties realize that failure to modify extant agreements would likely land the municipality in bankruptcy court, all parties should be willing to work very hard to achieve consensual modification of burdensome agreements.”

Rare Option

Chapter 9 bankruptcy is rare, according to the American Bankruptcy Institute in Alexandria, Virginia.

Only six occurred during the first three quarters of 2009, the latest period for which data is available. There were four in 2008. Since 1980, we’ve seen 227 instances, the peak year being 1991, with 18. Most have involved utilities or special districts, according to Spiotto, not cities or counties.

States can’t enter Chapter 9 bankruptcy, and 26 of them prohibit their municipalities from filing, according to Knox and Levinson...

...That hasn’t stopped municipalities from talking about it more than they have since 1994, when Orange County, California, suffered through the country’s biggest municipal bankruptcy. Bondholders have to worry if it’s more than just talk.

Disclosure: No positions