Muni Bonds: Starting to Heat Up

Rodney Johnson |

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I’m not above keeping the money that I find in the clothes dryer. I’m happy to snag a single or even a five-dollar bill, but coins are also appreciated. The cash usually belongs to one of the kids, and I figure that if they were careless enough to let it go through the laundry, then obviously they don’t miss it.

This collecting of capital is in keeping with how I view the rest of my funds. Not only do I like to grow my assets, but I like to keep them as well, which is why I’m so fond of municipal bonds. These investments are typically tax exempt, so all of my earnings escape the gaze of the taxman, who can’t seem to get enough of what other people have.

This boring corner of the investment arena generally has all the excitement of a pet rock circus, but recently that’s changed. The new worries in the muni market might be troubling for some, but they give the rest of us a chance to snag assets on the cheap.

The long-term default rate in municipal bonds is a fraction of one percent. Only 0.17% of the bonds in the S&P Municipal Bond Index defaulted in 2014. This followed an even lower rate of 0.11% in 2013.

Based on this information, the risk of default appears exceptionally low. But the historical numbers don’t tell the whole story. There are two big caveats: First, a spectacular default in one city can cloud the entire market. Besides that, municipalities have new challenges that they have not faced before.

As for big defaults in the news, Detroit comes to mind. I’ve written before that its bondholders were treated worse in the bankruptcy than the letter of the law allowed. They brought home pennies on the dollar, while other creditors that were subordinate were made whole. This is a recurring theme across the country, so it’s no surprise, but it still serves as a warning to all municipal bond investors.

General obligation bonds state that the payments to bondholders are backed by the full faith and credit of the issuer, but in times of crisis, issuers don’t hold up their end of the bargain. Bond buyers are forced to accept less than they’re owed, and so far, they haven’t prevailed when challenging these outcomes. Creditors of cities like Pritchard, Alabama, Central Falls, Rhode Island, and Stockton, California have all suffered similar fates.

Puerto Rico is Set to be the Next Big Bankruptcy

A large bankruptcy on the horizon is Puerto Rico. In fact, it defaulted on its bonds last Monday. The US territory can’t pay its bills, so now it’s calling on all “stakeholders” to negotiate in “good faith.”

In other words, they want bondholders to agree upfront to cut the face value of what the territory owes them. This is despite the fact that many of those bondholders own general obligation bonds – which, again, are backed by full faith and credit of the territory. Territory officials are putting investors on notice that even though their constitution states debts must be paid before all other creditors, the government won’t cut any operational expenses (salaries, services, etc.) in order to make good on their principal and interest payments.

Adding to the uncertainty unleashed by the proceedings in recent municipal bankruptcies and the developments in Puerto Rico are the ballooning costs of pensions and health care benefits that cities and states around the country are facing. While unfunded pension liabilities are old news, the accounting board governing these entities only recently required that unfunded health care liabilities be included in city and state calculations of financial health.

The results are ugly. In addition to a trillion-dollar unfunded pension problem, it’s now clear that municipalities in the US also have a trillion-dollar unfunded healthcare problem. As these figures make it onto the financial statements, the fact that many cities and even a few states are bankrupt on paper will start to sink in with ratings companies, analysts, and investors.

While none of this is good news, it can have a good outcome.

The combination of high-profile bankruptcies, bondholder treatment in bankruptcy proceedings, the direction of negotiations in Puerto Rico, and the sudden addition of a trillion dollars in liabilities to books should produce enough uncertainty and concern in the municipal market to drive prices down and yields higher.

The negative news cycle could even cast a pall over all municipal bonds, giving investors a chance to pick up high quality names on the cheap.

Where Work and Patience Pay Off.

The key to buying municipal bonds is the same as purchasing any other investment. Do your homework. The old way of buying bonds – look at the rating and pull the trigger – is dead. Anyone who trusts a rating deserves the outcome…whatever it is.

Instead, investors can and should review the finances of bond issuers and determine for themselves how likely it is the city or state will make good on its debts. I know the overwhelming majority of them will…but not all.

Once investors have found and purchased bonds issued by solid municipalities, then they must be patient. The negative news over municipal bonds won’t go away anytime soon.

This particular market will likely be roiled by turmoil as the problems in cities and states in tough financial positions, like Chicago and Illinois, come to the surface. But as long as investors did their homework and hold solid bonds, they won’t have to worry.

Their principal and interest will keep landing in their mailbox. And the best part is, they still won’t have to send any of it to the taxman.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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