Money Matters: A muni meltdown, or an opportunity?

By Sharon L. Thornton
The Daily Record Newswire

Recently, financial columnists have forecast a rocky road for the municipal bond market. In a December episode of "60 Minutes," Meredith Whitney (a banking analyst at her own firm) forecasted severe defaults across the municipal bond market. Meredith went as far as to state: "50 to 100 sizeable defaults. ... This will amount to hundreds of billions dollars' worth of defaults."

Historically, the one-year record of defaults was in 2008, estimated at a bit over $8 billion dollars. Should this one "guru" be correct, it would mean an increase of over 2,400 percent of the previous record!

While one cannot say there will not and should not be some municipal "belt tightening," forecasting such widespread default simply does not give the municipal market enough credit. One of the most annoying aspects of the news coverage is that municipal debt is talked about in general terms.

No one mentions the diversity among the borrowers in the marketplace. Further, with that diversity comes different types of commitments and sources for repaying the debt, such as taxes and specific revenues.

Additionally, one must understand that most defaults in the modern era are not governmental in nature or what one might deem real municipal debt. Instead, they are corporate or nonprofit borrowings disguised as some type of municipal debt enabling them to get the lower rates of tax-free financing. In fact, a 30-year study by Moody's (1970-2000) tallied 18 municipal defaults of which 10 were not-for-profit hospitals.

Since 1970 to present, municipal defaults have averaged over one per year. The average recovery rate from defaulted bonds is approximately 85 percent according to Moody's Investors Service. In 2009, the weighted average recovery rate for corporate bonds was 34.1 percent of par value and a median of 24.9 percent according to Fitch Ratings Service. Obviously, the defaulted municipal bond investor recovered much more than the average corporate bond investor.

Further, since 1930, Moody's has recorded nearly 2,000 defaults by non-financial major corporations. Contrast this with the fact that since 1930, zero states have defaulted on their debt. (States are not allowed to declare bankruptcy.)

In the infamous Orange County, Calif. bankruptcy, bonds did not default at all. Instead, services were cut, taxes raised and all of the $1.6 billion owed to bond holders was repaid. The act of bankruptcy seen here allowed Orange County the time to remedy their misfortune and contract expenses.

What, then, differentiates municipalities from corporate issuers and how can they lower their absolute risk of default? First, municipalities have far more ability to increase revenues than companies do. Second, the size of the problem relative to revenue capacity is small. For example, it is estimated that Illinois could cure their budget deficit with a 2 percent increase in the state income tax. Third, municipalities have the ability to cut costs without reducing revenues. As labor is the highest expense for most, reducing headcount and mandatory unpaid furloughs would prove to be more than just a "Band-Aid."

Fourth, predominately, municipalities are required to give the highest priority to debt service payments. This means that the first tax dollar pays bond holders -- not the last. Last, budget deficits will be getting smaller, not larger, as the economy improves and cost-cutting measures are instituted.

As with any negative news, opportunity also exists. Legendary Bill Gross of Pimco recently committed personal funds to the municipal market because a weaker market meant an investment opportunity. However, as with any investment opportunity, it is important to maintain a diversified portfolio. By employing extreme diversification, the investor has the greater potential to weather all possibilities.


Sharon L. Thornton is senior director of investments for Karpus Investment Management in Pittsford, N.Y. She can be reached at (585) 586-4680.

Published: Thu, Jan 6, 2011


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