What we’ve learned from municipal distress
This is a guest post from Joe Rosenblum, the director of Municipal Bond Credit Research at AllianceBernstein.
Is the municipal bond market on the verge of collapse? You might think so, given the blaring headlines about a few big disasters in the last year. But the truth is that poor decision making, not systemic issues, has caused the most serious problems.
Jefferson County, Alabama, and Vallejo, California, filed for Chapter 9 bankruptcy protection. Receivers were appointed for Central Falls, Rhode Island, and Harrisburg, Pennsylvania. Stockton, California, is deferring debt-service payments (though bondholders continue to get paid from other sources) as it goes through a state-authorized mediation process with its creditors. And most recently, Detroit agreed with the State of Michigan on a shared fiscal oversight process to avoid bankruptcy.
There is no question that state and local governments are facing financial hardship as a result of the weak economic recovery and its impact on tax receipts. But this is not the first time local governments have been challenged or have defaulted on their debt or filed for bankruptcy protection.
In the 37 years since New York City’s brush with default in 1975, there have been a slew of other bankruptcies, defaults and near-defaults. Prominent among them were cases involving the Washington Public Power Supply System (WPPSS); Cleveland, Ohio; Bridgeport, Connecticut; Yonkers, New York; Erie County, New York; and Orange County, California. All of them also grabbed headlines in their day.
Here are some lessons we learned from them:
- Municipal bonds are not risk free
Every year some municipal bonds default. The overwhelming majority are in subsectors that are more corporate in character than most municipals, such as industrial development, hospital revenue, senior living, or real estate-based bonds. On occasion, even more traditional tax-backed or municipal utility revenue bonds default. A more common threat to bondholder value is credit deterioration; many municipal bonds are downgraded for reasons less serious than outright default. Downgrades can drive down bond prices, so research into credit trends is important.
Nevertheless, the municipal bond market – particularly the debt issued by state and local governments for traditional projects like schools, roads, water and sewer systems, and publicly owned utilities – has an excellent history of safety. Over the last 20 years, the annual default rate never exceeded the 0.25 percent of bonds outstanding that occurred in 2008 and 2009. While we expect the default rate to rise in the near term, we don’t expect the increase to be significant.
- Default is the issue, not bankruptcy
Central Falls, Rhode Island, filed for Chapter 9 bankruptcy last fall but has continued to meet its debt-service payments. A municipality can default on a bond without filing a bankruptcy, and a bankruptcy doesn’t automatically result in defaults. Municipal bankruptcies remain rare; their goal is to give municipalities facing huge financial problems a mechanism to work out their problems. Taking this step is neither a guarantee of debt repayment nor an automatic default – the outcome depends on the municipality’s specific circumstances.
- Liquidity is key
Municipalities provide essential services and can’t pack up and disappear the way a corporation can. But poor budgeting, weak revenues and poor control over expenses can lead to insufficient revenues and insufficient liquidity to pay all required expenses, including debt service. For the municipal analyst, paying attention to cash positions and balance sheets is crucial.
- Beware of the overzealous treasurer
In an effort to win big, the occasional local official has invested local funds in inappropriately risky financial products. The Orange County, California, bankruptcy in 1994 showed the fiscal havoc that officials can wreak when they lose focus on capital preservation.
- Beware of project overreach
The recent troubles for Harrisburg, Pennsylvania, and Jefferson County, Alabama, show what can happen when a municipality undertakes a project that is too large in scope and not well-conceived or -implemented. Harrisburg guaranteed the debt of a trash incinerator; Jefferson County undertook the extensive upgrade of a sewer system. WPPSS provides the municipal market’s most notorious example of project overreach. Its failed effort to build five nuclear power-generating plants simultaneously would have made it infamous even without its acronym, which investors pronounced “Whoops.”
- There is no such thing as an unlimited tax pledge or promise to raise rates
Municipalities cannot simply expect to raise taxes or rates to repay debt. At some point, doing so becomes economically or politically unfeasible.
- State oversight can be a bondholder’s best friend
One of the complicating factors about the municipal market is that local governments operate within state constitutional and statutory provisions. Some states are much more proactive than others in responding to local government distress. When Orange County filed for bankruptcy in 2004, California did little to support it. The same was true when Vallejo filed for bankruptcy in 2009. But New York State has been much more involved in solving the problems of its distressed local governments. Learning from New York City’s experience in the 1970s, the state has in several cases created “control boards” to help bring local budgets back into balance. Michigan and Pennsylvania, too, have been closely involved in local financial turnarounds. Rhode Island has recently started down a similar path.
Overall, the municipal bond market is large and complicated, with more than 40,000 municipal issuers and over $3.7 trillion in debt outstanding. The overwhelming majority of these issuers will continue to make the decisions needed to balance their budgets and honor their contractual commitments. But as we have seen in the past, there will always be outliers whose poor decisions threaten their financial health.