The Confusing State of Municipal Bonds

Over time, some people have feared that California may slide into the Pacific Ocean due to an earthquake.  A more immediate concern is whether California will descend into an abyss due to its financial problems.  Many states and municipalities face similar difficulties, causing the safety of municipal bonds to be questioned.

Hopefully, we won't revisit the debt crisis of 1835, when the "United States succumbed to a craze for building railroads, canals, and turnpikes, all backed by state credit."  As Ron Chernow describes in the book "The House of Morgan," the state debt had been largely marketed in London to British and European investors.  Some states chose to stop making interest payments as "American legislators found it easier to pander to the hatred of foreign bankers rather than to raise new taxes to service the debt."  No wonder "British investors cursed America as a land of cheats, rascals, and ingrates."

Today, there are a number of reasons why people are worried about "munis," as they are affectionately known.  For starters, many government entities face  budget deficits, putting their ability to pay back their bonds into question.  Government revenues are recovering slowly as we come out of the recession, while demand for services has increased.  Local governments must also deal with under-funded pension plans for public employees. 

Muni bonds also seem less attractive because most insured bonds have to stand on their own as far as credit-worthiness.  A large percentage of munis were insured by private, AAA-rated companies, making the bonds seem extremely safe.  But these insurance companies lost their AAA status in the recent credit crisis and are no longer trusted to cover a bond's payment obligation in the case of a default.

The bleak status of municipal bonds may, however, be exaggerated for the following reasons:

  • States are not facing a particularly large debt crisis.  State debt is around 7.3% of gross state product.  By comparison, the troubled European countries have debt-to-GDP ratios above 100%.
  • Most state constitutions require that they have balanced budgets each year.
  • State governments are not allowed to file for bankruptcy.  Although half the states allow local governments to file for bankruptcy, this has been a rare occurrence.
  • Local governments' debt service on its existing bonds are relatively low -- around 4% to 8% of total expenditures per year.
  • General obligation bonds are backed by the taxing power of the entity that issued the bond.  Revenue bonds are backed by the money generated from the asset built with the bond money; e.g., toll roads.
  • States and local governments rely on issuing bonds to raise money, so they are very careful to avoid harming their ability to raise more capital in the future.
  • Under-funded pension liabilities, although serious, are a long-term matter and do not impinge on governments’ ability to service their current debt.

At the end of the day, investing in municipal bonds has become more complicated.  Greater due diligence is necessary before buying individual bonds.  A reasonable alternative is to utilize mutual funds, which can offer diversification and professional management; although, you still need to determine that the bond fund is not taking on more risk that you are comfortable with.

Words of Wisdom

Governments are like underwear.  They need to be changed often and for the same reason. -- Italian Proverb