Reuters Money

Rick Ashburn is a chartered financial analyst and the founding Principal Chief Investment Officer of Creekside Partners, based in Lafayette, California. The opinions expressed here are his own.

It was the best of times. It was the worst of times. If you’re a muni bond investor, you’re probably wondering what time it really is. If you listen to recent commentary by Meredith Whitney and Peter Schiff, it’s the worst of times and time to get out of town with your head still attached.

Without delving into the qualifications or experience of these two with regard to municipal credit (none), I instead offer some sensible analysis of the muni bond market. The muni bond market breaks down into two very distinct types of credits. Some bonds are at risk in tough times; others really are not. The categorical tarnishing of all muni credits, as on the recent 60 Minutes segment, is stunningly bad commentary.

Credit is defined as the ability to pay and the willingness to pay. Municipalities face pressure on both fronts since they are, at heart, political bodies. Much of the investment world is engaged in the classic credit balancing test. They are adding up all the liabilities on one side of the scale and all of the revenues and assets on the other side.

The trick is then to decide which way it tips. And that is tricky to do, I must admit. I don’t know the future, and I wonder how these talking heads on CNBC seem to know it with such certainty. In my 25 years, I’ve seen most bad investment outcomes boil down to overconfidence in one’s ability to predict the future. So, we don’t even try.

Our approach to the ability-vs-willingness credit analysis puzzle is simple: remove one of the variables. Don’t take “willingness” risk. Most of your worries go away when you do this.

Whitney and others are correct in pointing out the long-term gap between revenues and expenditures in many state and local governments. These large gaps can threaten the ability to make bond payments. More importantly – they can affect the willingness to make bond payments. While surely there are municipal entities with simply too much debt, those are quite rare. We see the more pressing issue to be a political one, where an elected body will choose to not generate the revenues or spending cuts sufficient to make room for bond payments. While bondholders will not take these actions lying down, and courts will side with bondholders nearly universally (contracts are enforceable, after all), we don’t want fights. We just want our bond payments on time.

Our solution is to concentrate on bonds without political, or appropriation, risk. If an elected body needs to sit down every year and take a vote on how to appropriate limited resources, there is a risk that they will choose not to pay bondholders in full and on time. Our credit review process therefore becomes a focus on the legal structure of the bond, instead of the traditional credit-quality issues of budgets and cash flows and balance sheets.

For example, many local governments issue debt whose payment is subject to an annual appropriation by the elected body. In California, the most common form of this debt is lease revenue bonds, or certificates of participation in an underlying property lease. The entity promises to put the annual payments in its budget, and the bondholder has certain protections against failure to do that. But at the heart of the matter, the legal structure of the bond puts the bondholder at the risk of the annual political process. In many states, even so-called general obligation bonds are, in reality, subject to the annual appropriation votes of elected officials. One can certainly imagine a scenario where a governmental body decides to stop cutting services and skip a few bond payments instead.

In contrast, other types of bonds are payable from dedicated revenue sources that cannot be re-directed to other services. In some states (California included), bonds can be authorized by voters, together with a property tax rate sufficient to pay off the debt. A city council in this case does not have to decide between making pension contributions and paying bondholders. The bond issue is, for all practical purposes, a standalone entity without competition over its revenues. A city or school district general obligation bond in California is not paid from the entity’s general budget. It is payable from a small (usually under 0.20 percent) property tax rate that is directly levied and collected by the county treasurer/tax collector. Because of this legal structure, the bond is highly secure. No matter the grave budget problems these local governments might face, our bonds will be paid. Even in the unlikely event of a municipal bankruptcy, our bond payments will continue to flow in full and on time.

We classify California local government general obligation bonds in the same credit category as United States treasury bonds. While we do not focus much outside California, there exist similar legal structures in other states. But not all. Be careful. Ask your adviser or broker whether the bond you are considering is subject to an annual appropriation process. If they don’t know the answer, move along to other investment choices such as Treasury or Agency debt.

Investors can also find bonds payable from monopoly utility revenues. Water, electric and sewer systems also provide opportunities to own bonds with reduced appropriation risk. These types of entities do not face the broad-based demands on their revenues that general purpose governments (eg, cities and counties) struggle with. Their financial lives are, in a very real sense, a lot simpler. We point out that some municipal revenue bonds, such as hospital systems, do not have monopolies in their markets and present the same risks as other appropriation debt.

Again, we agree that some state and local governments face severe budget problems. Perhaps these budget problems are intractable and will only be solved via a debt restructuring. The solution for a bondholder? Stay out of the middle of that fight. Own state-issued general obligation debt, and local government debt that is payable from a dedicated revenue stream that cannot be directed to other purposes.