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By Christine Benz | 08-01-2012 01:00 PM

Will the Next Municipal Shoe Drop on Bondholders?

Despite the scare of recent bankruptcies and downgrades, municipalities have the resources to continue making bond payments, while looming tax increases likely won't affect muni demand, says Morningstar's Jeff Westergaard.

Christine Benz: Hi. I'm Christine Benz from Morningstar.com. In the wake of a few high-profile bankruptcies, municipal-bond investors might be feeling nervous that there are other shoes to drop. Joining me to share his current outlook for the muni market is Jeff Westergaard, director of municipal analytics for Morningstar.

Jeff, thank you so much for being here.

Jeff Westergaard: Thanks for having me, Christine.

Benz: Jeff, let's start by doing a little stage setting. We have seen these bankruptcies from some California municipalities over the past several months. Let's talk about what happens to bondholders in a situation like that. They own the bond; the municipality runs into trouble. What happens to you as a bondholder at that juncture?

Westergaard: Well, that's a great question, and I think that's one where there's a lot of confusion, or at the very least uncertainty about. There are a couple of terms that we need to clarify right off the bat. One is bankruptcy, which is in this case a municipal entity availing itself of Chapter 9, which is part of the U.S. Bankruptcy Code, to protect itself from creditors. The other term is default, which is when an entity chooses not to pay bondholders. And just to be clear, what we've seen so far have been bankruptcies not defaults. It remains to be seen if these bankruptcies will lead to defaults, and I don't have an opinion on that to share with your viewers. But it's important to keep those two terms clear, and furthermore it's important to understand that 34 states do allow local municipalities to use Chapter 9; 16 don't allow it. And no state can declare bankruptcy, so that kind of sets the stage for what the scope of bankruptcy might be from a legal standpoint at any rate.

But as you said, it's really these California municipalities in the past few weeks that have really kind of refocused on this issue of bankruptcy in the municipal market. Prior to that in 2009, another California city, Vallejo, Calif., had chosen Chapter 9. It's important to note that Vallejo did not default on its bonds. It made current all payments in that intervening period of time, and in this year, came out of Chapter 9 bankruptcy. Another high-profile situation was Harrisburg, Pa. It hasn't declared bankruptcy. It hasn't defaulted. But it has been in the news.

In California, you've got a confluence of events. Some are kind of one-offs. One is the situation at Mammoth Lakes, where it lost a court suit and had to make a large payment to a developer. That's a pretty unusual circumstance. In the case of the others, San Bernardino and Stockton, they're really I think victims of the housing bubble and the financial crisis, and the resulting Great Recession. So, to kind of move on to the second part of your question, are there other shoes to drop? I think it's important for investors to understand that we have just come out of the worst recession since the Great Depression, and many people are calling it the Great Recession. The stress on states and then by extension local and municipal governments has been severe. So, even if it isn't bankruptcy or default, there certainly has been stress that's impacted the credit quality of these issuers and another term that some investors may have heard, which is being called a super downgrade. That term means a multiple notch lowering of rating of a bond by one of the rating agencies. We've seen examples of those, too. All of those present risks to investors.

In the case of the super downgrade, the value of your investment is going to drop precipitously if the rating drops precipitously, suddenly overnight.

Benz: And presumably, if there is a bankruptcy filing from your municipality and you hold their bonds . . .

Westergaard: That's not good either. The worst of course is default because then you're not getting the income, and the principal that you expected is jeopardized. And for municipal-bond investors, more often than not they're investing for a return of principal as much as return on principal. Both of those things are jeopardized.

So are there more shoes to drop? I think, the prudent answer would be, we'll have to see, but it's not unlikely to imagine that they will. On the other hand, with these kind of apocalyptic scenarios that I think most people have now commonly associated with Meredith Whitney's 60 Minutes comments, at Morningstar we do not expect anything like that to happen, and I think, the vast majority of commentary that I've read over that period of time really kind of agrees with our position. Now, municipal governments, whether state or local, have a tremendous toolkit to deal with financial and fiscal stress and strain that you just don't have if you're a corporation. That's one of the reasons the historical default rate for municipals is exponentially smaller, second only to Treasuries in fact in terms of safety in the asset class.

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