The Hidden Risk In The Muni Bond Market

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by: Financial Freedom Institute

Summary

A tiny city in Colorado is involved in a seminal court case regarding paying its obligation in a muni bond issuance.

The city is trying to renege on principal and interest in a $25 million bond issue.

If it succeeds in court, it will establish a dangerous precedent - that any municipality can renege on its obligation under certain circumstances.

This could create substantial increased risk for muni bond issues, and increase risk in the muni market.

There's a coming storm in the municipal bond market, triggered by the tiny city of Lamar, Colorado, which wants to avoid servicing its share of debt as part of a power cooperative because of a broader dispute. Should a court grant its request, it could create shock waves throughout the muni bond sector.

Sure, there is always a cry whenever a municipality defaults and, sometimes, investors extrapolate one case and argue that the muni bond market will implode. The point here is not to definitively say the sky is falling, but to uncover risk that most investors are probably entirely unaware of. The risk is significant in this case because of the precedent that would be set.

In 1979, six Colorado municipalities created the Arkansas River Power Authority (ARPA), which would provide electricity to its members. Cooperatives form to spread the cost of electricity-creating plants instead of each city funding its own prohibitively expensive operation.

In 2004, ARPA launched the Lamar Repowering Project (LRP), which would retire the plant's gas-fired boiler and convert it to coal-firing - a decision made by the Lamar Utilities Board. Cost overruns and engineering mishaps resulted in a boiler with substandard emissions that could not be replaced, and the plant was shut down after an environmental group's lawsuit.

Critically, all of LRP's funding, including debt increases, were directly approved by Lamar. In addition, the Lamar Utilities Board was named as the Operating Agent for the LRP, and thus the city was uniquely positioned to have operational control.

The problem? The LRP was funded by a municipal bond issuance, and the co-op's members must repay the debt with interest. Yet while the other five cities have all bit the bullet and agreed on repayment, Lamar has filed suit to avoid having to pay back the debt or interest.

This is particularly bizarre, considering the US District Court found the boiler's manufacturer was at fault, and not the ARPA. Why would Lamar take out its rage on the co-op rather than the perpetrator behind the fiasco?

This is a potentially cataclysmic move on Lamar's part - for itself, for municipalities around the country, for vendors doing business with America's localities, and possibly for the broader muni bond market where millions of Americans are invested.

For Lamar, it's particularly foolish. For starters, Lamar has dropped $1.65 million to the law firm of Allen & Vellone as part of this litigation, and that doesn't include fees from November onward, or the heftier monthly fees assessed when the trial begins in March. On annual basis, that cost is roughly the same as paying interest on the debt.

Going forward, bond issuers will look at Lamar, wondering if it will renege on promises at the first sign of trouble. Infrastructure or school improvements could be put at risk. Trying to issue bonds that find actual buyers may prove challenging at best. Those bonds that do sell will likely require far higher interest rates than comparable municipalities might enjoy. After the City of Stockton, California went bankrupt in 2012, its subsequent bond issues were priced as high as 8%.

In turn, financial institutions that insure bonds will beg off. What insurer wants to insure a deadbeat municipality?

Furthermore, what happens if Lamar decides to default on its 1999 Water Bond, which it makes payments of over $17,000 per month? Who takes the loss then?

Lamar's vendors should be alarmed. Take the Colorado Intergovernmental Risk Sharing Agency (CIRSA), which is a multi-municipality self-insurance pool that Lamar paid about $500,000 to in 2016. CIRSA and its members should demand that Lamar pay its share up-front each year to avoid getting stiffed, since other municipalities rely on such contributions.

Lamar's move could cause a contagion to other municipalities facing similar problems. Construction issues are not unique to ARPA, and neither are overzealous environmental groups. Bond buyers and insurers are going to examine municipalities that bear any resemblance to Lamar, or any similar project with environmental concerns, with an eye towards demanding higher rates of return for the commensurate risk.

The result is that thousands of small municipalities that need capital for vital projects will either not be able to access it, contributing to our nation's failing infrastructure, or it will come at higher cost.

This could easily create a cascade of selling across the entire $4 trillion municipal bond market. If Lamar got this far with its case and, especially if it should win, then it could occur with any municipality at any time. Imagine one municipality after another simply deciding it wasn't going to repay its debts because of the slightest adverse occurrence.

Muni bonds are favored by retired investors for their perceived safety and tax-free yields. The last thing the country needs is for one tiny city to muck up the retirement plan of millions of retired Americans.

Therein lies the hidden risk in the muni bond market. It's not as if some huge cascade will occur overnight, but you can bet that municipalities that want to renege on deals can and will do so if there is a court precedent. Investors may think higher rates on muni bonds will be welcome, but not if they come with higher risks of default, and if insurers run for cover.

Municipalities around the country, and local vendors, should pressure Lamar to pay its fair share of debt. Otherwise, it's equivalent to a teacher punishing the entire class for one student's bad behavior, and it's up to the class to scold the unruly child for the betterment of all.

As far as muni bond investments go, stay away from individual issues. That's never a good idea anyway, and now there's even more reason to avoid them. You should be adverse to muni bonds in this environment, until this matter is resolved.

If you must be in muni bonds for some reason, stay in large diversified funds like iShares National Muni Bond ETF (NYSEARCA:MUB), SPDR Nuveen Barclays Short Term Municipal Bond ETF (NYSEARCA:SHM), and SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA:TFI).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.