A few months ago I wrote about the potential for trouble in the municipal bond market as some cities, counties or states struggle with shrinking revenues and trying to cut expenditures while delivering the services the citizens have grown to expect.
In early September, Harrisburg, Penn., announced it would not make a $3.29 million interest payment due later this month. The choice was made by the mayor after deciding it could not cut public safety services any further.
Earlier this year, Jefferson County, Ala., and Crawfordsville, Ind., missed interest payments on outstanding debt issues. All told, the municipal bond default rate is running about three times the normal long-term, historical level. Interestingly, that historical rate is about one third of the default rate of investment grade corporate bonds. This means that quality corporate bonds, at least at the moment, are generally considered about as safe as investing in municipal bonds.
We all know that municipal bonds provide tax-free interest payments, and this is what has made them attractive to investors in the top tax brackets. Presently, 10 year AAA rated municipal bonds on average are yielding about 2.4 percent. While 10 year U.S. treasury bonds are yielding about 2.7 percent. Of course, the after-tax yield on the treasury bond is lower and would equal about 1.75 percent for an investor in the top tax bracket.
So, although yields in general remain very low for high quality bonds of all types, municipal bonds are offering a distinct edge compared to treasury issued securities. Apparently, this edge comes with a risk – that risk is if the municipality that issued the bond defaults, the investors may not receive the interest payments they were promised and could be at risk for loss of a portion of the principal invested in the bonds.
Many munis are insured. When the municipality issues the bonds, it buys insurance from a municipal bond insurance company to give the investors peace of mind that in the case of a budget struggle for the issuing city, county, or state, the investors will still receive their interest payments and principal. Insured municipals generally have higher ratings and pay lower yields.
The tight budget situations in many cities and locals are presenting an interesting situation with Harrisburg, Pa., being a great example. The leaders of the city decided they could not cut services to the residents any more and decided not to pay the interest to the bond investors rather than lay off police, fireman, or other city workers. The bonds were insured, so now the bond insurance company will have to pay the investors the missed interest payment.
This developing situation has long-term ramifications for municipalities and for investors who want to buy tax-free bonds. If the municipalities start relying on the insurance to make payments, the insurance companies will be very hesitant to write coverage for future bond issues when these cities and states need to raise capital for future projects. Without insurance, the investors will demand higher interest yields on the bonds before they will take the risk of buying the uninsured debt. Of course, the higher interest cost ends up getting passed along to the taxpayers in the municipalities.
I’m not predicting a total breakdown of the municipal bonds markets, but I do believe we will see more defaults and that this segment of investing, which for several decades has been a pretty simple and easy place to navigate, is about to get more interesting and risky.
Investors can reduce their risk of the negative impact of a default by staying very diversified and not putting too much of their portfolio in the bonds of one municipality. Mutual funds or exchange traded funds (ETFs) are great tools to help with the diversification process, although there is a cost of owning the fund, which may reduce the yield.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.