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A Tale of Two Cities

An analysis of two obligors shows two municipalities at opposite ends of the credit spectrum.

Rachel Barkley, 08/28/2012

Municipal bonds, traditionally one of the safest investment asset classes, have provided a stable source of income for investors even in environments of economic volatility. But with the demise of the bond insurance industry, the undermined credibility of credit-rating agencies, and increased media attention on the funding shortfalls faced by state and local governments, investors have put a renewed focus on the underlying credit quality of municipal issuers and obligors of debt.

The muni market is vast, with 1.5 million active bonds and more than 100,000 unique issuers, each of whom offers a variety of debt securities to the market. Assessing credit quality in the muni market can be difficult for investors because of the wide range of credit factors that influence obligors’ ability or willingness to repay their debt.

Four Pillars
Morningstar approaches this problem by basing its municipal credit analysis on four pillars: economic strength, financial condition, debt and long-term-liabilities profile, and management and operating environment. Morningstar analysts then determine the overall credit quality of the issuer.

To illustrate how widely the credit quality of local governments can vary, we have chosen two cities of similar populations that lie on opposite ends of the credit spectrum: Detroit, Mich., and San Antonio, Texas.

Detroit has a pressured credit profile characterized by weak economic and demographic trends, limited financial liquidity, and very high debt levels. The city is under strict state oversight, and its ability to meet operating and debt obligations is questionable. Conversely, San Antonio has a strong credit profile with limited weaknesses and minimal risk exposure to bondholders. San Antonio’s local economy is diverse and remained resilient through the nation’s recent recession. Its strong management practices have allowed the city to keep its financial flexibility while continuing to provide healthy service levels.

Economic Strength
When we look at a city’s economic strength, we analyze the size, diversity, and stability of the area economy. The property-tax base is a main factor for local governments, but we also examine demographic data, such as population and employment.

San Antonio’s economy is strong and growing, anchored in military and government. The unemployment rate is below the national average. Wealth indexes are satisfactory, aided by a low cost of living and economic expansion. Bucking trends of the national housing correction, property values remain stable. Detroit’s economic and demographic profile is extremely weak. Over the past decade, Detroit’s population has fallen by nearly 25%, bringing it to its lowest level since 1910. Although this means that the labor force has declined in number, unemployment rates remain exceptionally high. Wealth levels are low with roughly one third of its residents living below the poverty line. Local industries are diversifying somewhat, but the area economy continues to be dominated by the volatile auto industry.

Financial Condition
Morningstar’s financial-condition pillar measures the issuer’s financial flexibility. For local governments, this includes consistency of operating results, reserve levels, revenue diversity and volatility, revenue and expenditure flexibility and liquidity levels.

Rachel Barkley is a municipal credit analyst with Morningstar.

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