Will Defaulted Harrisburg Bonds Cause a Domino Redemption Effect?

Includes: EIP, MPA, NQP
by: Robert Kane

The city of Harrisburg, PA. has been in financial trouble since July 2009 when they first disclosed a bond default for their fiscally mismanaged local incinerator plant. In August 2010, the city of Harrisburg also defaulted on $3.29 million of its own General Obligation bonds. Surely they are having financial problems there.

So why does Moody’s (NYSE:MCO) and S&P still have top ratings (AA3 and AAA) on various Harrisburg defaulted bonds? How are such top credit ratings even possible given Harrisburg’s obvious financial troubles. And most importantly, what impact does this have on investors of muni bond ETFs and closed end funds?

The Harrisburg default shows that this city isn't able to cover its basic regular interest payments. More troubling is that it won't step up to protect the incinerator bondholders and either will the state via Dauphin County who backed away too this week.

While portions of these bonds are insured, that shouldn’t provide much comfort because of the shaky financial position of most muni bond insurers. This includes AMBAC (ABK), the bond insurer backstopping the defaulted harrisburg GO bonds. In AMBAC'S 2010 10Q filing they admitted we have “insufficient capital” to and “ may need to file for bankruptcy”. Most muni bond insurers except Assured Guaranteed are on thin ice too.

The problem is a small flurry of muni bond defaults that require insurance payments could cause muni bond insurers to file for bankruptcy. And then bondholders are really left holding the bag.

So how does this potentially affect investors? Well, the mainstream press has already started pointing to Harrisburg as the beginning of a widespread muni bond collapse. If these reckless notions gain hold it could result in a selloff in state specific bond CEFs such as Eaton Vance Insured PA. Municipal Bond Fund (NYSEMKT:EIP), BlackRock MuniYield PA. Insured Fund (NYSE:MPA), and Nuveen PA. Investment Quality Municipal Fund (NYSE:NQP)

Disclosure: No positions