Much media attention has recently focused on the financial challenges facing municipal markets and the possibility of defaults in municipal bonds. Chevy Chase Trust manages over $1.1 billion of municipal bonds with a constant emphasis on preservation of principal.
Understanding the Municipal Markets, History and Risks
Headline news in the municipal markets can be disconcerting and there are certainly financial stresses in some sectors of the municipal marketplace. Chevy Chase Trust closely monitors many factors, such as: 48 states faced budget shortfalls in fiscal year 2010 and at least 46 face deficits in fiscal year 2011; Federal support of $135-$140 billion from the American Recovery and Reinvestment Act over the next few years may be inadequate to solve the problem; credit default swaps on state debt are at their most pessimistic levels; unfunded public-pension liabilities in the U.S. totaled over $457 billion in 2008; and in some states pension obligation debt is senior to bond debt in credit stature. Some have seized on this data to proclaim municipal markets are on the verge of financial collapse.
We do not believe we are heading toward systemic defaults. Government and municipal projects do face significant challenges in a recessionary environment. We do not discount the risks and concerns. However, there are core market characteristics that support the long-term credit worthiness of municipal markets.
It is important to understand the structure of the municipal marketplace and the history of defaults. While the past does not always tell the future, it often provides useful insights.
- Market structure and perspective: The municipal bond marketplace is very diverse. There is over $3 trillion in outstanding debt and more than 60,000 state and local governments, districts, authorities and other issuers active in the municipal market. Each municipal issuer has unique financial characteristics. We look carefully at each and independently judge their strengths and weaknesses. Some bonds have inherently greater risk characteristics. We recognize defaults in some areas of the municipal bond universe are rising. However, in the safest sectors, default rates are effectively zero. Rising default rates have been confined to the riskiest, most speculative municipal sectors where Chevy Chase Trust does not typically invest.
- History: A Moody’s study found credit loss rates across all municipal bonds from 1970 to 2000 were lower than that for triple-A-rated corporate bonds.
The Moody’s study reported the default rate on investment-grade municipals over the past 40 years was 0.03%, compared with a default rate of 0.97% for comparable rated corporate issues. Additionally, investors eventually recouped an average of 67 cents on the dollar for defaulted municipal bonds.
- From 1970 to 2000 among general-obligation and essential-service municipal bonds (60% of issuers surveyed) the default rate was exactly zero.
- During the Great Depression, from 1929 to 1937, the default rate on municipal bonds was 16.2% of outstanding debt. However, the estimated loss rate was a mere 0.5%.
- Bondholders involved in the Orange County, California default of 1994 recovered 100% of principal and interest.
- The amount of bonds currently in default total $6.3 billion—or less than 0.2% of the current market—across 221 issues. Only 14 of these issues carried a major credit agency’s bond rating at the time of default, and more than half of the total dollar amount in default ($3.8 billion) is attributable to a single issuer—Jefferson County, Alabama.
Projections in the Municipal Bond Market
Declining tax revenues, reduced assessments and decreased consumer spending have placed financial stress on bonds backed by the full faith and credit of issuers as well as those supported by dedicated revenue sources. Chevy Chase Trust focuses on analyzing and assessing the risks of each bond issue. In general, we believe that municipal governments are more likely to cut services, raise taxes and delay projects than default on debt.
Additionally, there are a number of structural supports for municipal debt holders.
- The ability to borrow funds is fundamental and critical to all municipalities. The event of default or declaration of Chapter 9 bankruptcy would critically impair an issuer’s ability to tap debt markets in the future. This is a significant deterrent and provides a strong incentive to control deficits and manage debt.
- State governments are required to submit balanced budgets. Most local governments are required to submit a balanced budget by their own state constitutional mandate.
- Interest rates are low and the cost of borrowing or refinancing debt has significantly decreased, allowing issuers to achieve cost savings through new financings.
- Municipalities can only file for Chapter 9 bankruptcy when financially insolvent. Chapter 9 is a form of reorganization, not liquidation. A municipality must be specifically authorized to file Chapter 9 by its home state. Currently, only 26 states authorize the use of Chapter 9, with many high hurdles to overcome before a municipality may file. There have only been roughly 500 Chapter 9 filings since 1934. As a comparison, in just the twelve month period ending March 31, 2009 there were approximately 1.5 million bankruptcies filed by corporations and individuals.
- State and local governments are not as financially sound as they were a few years ago. However, the rate of decline is slowing. Most governments have taken the difficult and often painful steps to remain solvent. Though unpleasant, these actions have been necessary and constructive. Numerous states have begun to restructure pension obligations, moving from defined benefit plans to less expensive plans that include defined contribution elements.
- The federal government has demonstrated its support for the municipal market with the creation of the $135-$140 billion American Recovery and Reinvestment Act, including the extremely successful Build America Bond program.
- Taxes, Taxes, Taxes- Tax rates are not going any lower. In 2011 we anticipate the maximum Federal income tax rate will be 39.6%. Municipal debt is not subject to Federal taxes and in many cases state taxes. As Federal tax rates rise (does anyone think they are going lower?) the benefit to owning municipal bonds becomes even greater.
We value the trust clients place in us and welcome the opportunity to answer questions. Please feel free to contact me or any member of our investment team.