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Will the Next Municipal Shoe Drop on Bondholders?

Christine Benz

Christine Benz: Hi. I'm Christine Benz from 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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Benz: Let's discuss just quickly what that toolkit is. They have some taxing authority. What else is in their toolkit that say a corporation would not have?

Westergaard: Well, instead of being subject to the vagaries of the market, these are entities, which exist legally. They serve a primary purpose is to deliver government services to a populace. They can be anything from operating an airport to just maintaining roads, sidewalks, schools, et cetera. These are all things people need. That's why we have governments; that's why we have municipal governments. So it's very much mom-and-pop Americana that these bonds are financing. The toolkit consists of various ways to raise revenues--again, all within a legal framework--but ways to raise revenues and ways to respond to cost constraints or lowering costs.

Some of the problems that the entities that have declared bankruptcies revolve around is bad judgment about the revenue stream either being maintained or increasing, and when you have severe deflation of housing prices and you are relying on property taxes that becomes a problem. Or [when you're] guaranteeing contracts to employees predicated on the revenue streams that disappear, then you're locked into a cost structure you can't support. Those are both signs of poor management and are not necessarily easy to identify. But again back to the toolkit, [there are] a lot of tools for municipal governments, state and local government, to avail themselves of.

Benz: So, Jeff, you mentioned the apocalyptic comments about the muni market back in late 2010, I believe, and that actually created a really good buying opportunity for muni investors. But I think we look back over the past year and a half plus, and munis have had a pretty good run since then. I want to ask you about valuations and where you think they stand in general?

Westergaard: A great question, and one that I think is best answered by trying to first talk about why people invest in municipals. I think, I made the comment a minute ago that muni investors oftentimes are return-of-principal investors. Another way to say that would be they would be buy-and-hold investors, so likely they'd take advantage of a tax-advantaged income stream in that period of time before return of principal. On the other hand, if you invest in some sort of a vehicle such as a mutual fund, you don't really have a maturity date; you really investing for income or return. So that can be important in terms of how we'd look at what you should do looking forward.

In terms of the interest-rate environment, it's interesting. If you look back to let's say the 1950s, so a very long-term view of interest rates. We went through a period where we had a very low interest-rate regime. Then it started rising in the '60s, not coincidentally that's when you really had a large systemic increase in federal government spending. Then of course, we had some shocks to the economy in the '70s, resulting in very high inflation, very low economic growth, stagflation for those who remember. Culminating in the early '80s with very, very high interest rates. Then a cyclical downturn of rates that lasted 20 years. Now if you go new millennium, we've had again a lot of economic shocks, a lot of volatility, but all within a base of very low interest rates. We find ourselves now probably at the culmination of that low interest-rate environment. So, what does the crystal ball say? Well, there's a lot of liquidity in the market, and that certainly I think plays a part in rates being as low as they are.

That being said, I'm not sure you could build a watertight case that this is something that can't last for some time moving forward. On the other hand, if the economy does get some traction--unemployment rates come down, employment increases, and we see less need for the Federal Reserve to provide liquidity and hold short-term rates near zero--I think any economist would say it's likely rates could go up, and they could do that relatively quickly.

Back to the real question, what are municipal-bond investors supposed to do? What's your goal and objective? If you're investing for a future liability, I don't think you should be in the game of trying to guess where interest rates are going, but that being said, there are certainly portfolio-construction strategies you can employ that would allow you to manage that risk more effectively than others. Two common portfolio structures--laddered portfolios or a barbell portfolio--I think are certainly for those investors who are constructing portfolios of individual bonds. Those are two things that should be considered.

That being said, I think, it is probably hard to make a case that rates are going to stay very, very low for a very long period of time. It doesn't seem to fit with the empirical history that we've seen of interest rates in this country during the last 50 years.

Benz: Last question for you, Jeff. I'd like to talk about potential tax hikes in the future. We're hearing about this new Medicare surtax that's going into effect in 2013 as well as higher taxes on dividends and capital gains. What do you think that will mean for muni demand, if anything?

Westergaard: Well, I'm not sure what it means …

Benz: And we don't know that those tax rates will definitely go higher either.

Westergaard: That's probably the biggest unknown.

Benz: Yes.

Westergaard: What is going to happen? I can tell you what I think might happen at least with the hypotheticals of what could happen, based on an analysis of let's say the last 20 years of tax rates and how they've impacted the muni market. And the simple answer is tax-rate changes don't seem to have a whole lot of effect on municipal rates, at least if you measure them as a ratio of Treasury rates. So, you look back to the tax cuts that were implemented early in the first term of the Bush administration, which also incorporated the lower income tax rates for dividends. There was a lot of, I'll call it, fear that that was going to have an adverse impact on demand for munis. I don't believe you can say that actually occurred. I don't think it had much effect at all in fact. You go back to interest rates that were increased during the first Bush administration back in the early '90s and subsequent lowering of rates, and then the increase in rates by the Clinton administration all through the '90s. I don't think you can draw very strong correlation between those marginal tax-rate changes and demand for municipals. So the short answer is, I don't think that's going to matter all that much.

Benz: Well, Jeff, thank you so much for taking the time to share your insights.

Westergaard: Thank you.

Benz: Thanks for watching. I'm Christine Benz for