How Scary Are Municipal Finances?

You don't have to look hard to find a reason to worry about municipal finances these days. Reports of a looming day of reckoning in the municipal-bond market from a wide array of commentators are ubiquitous. Former Los Angeles mayor Richard Riordan took to the Wall Street Journal's editorial pages to predict that the country's second-largest city would declare bankruptcy before 2014. Testifying before the Financial Crisis Inquiry Commission in June, Warren Buffett sounded alarms about the "terrible" financial distress facing many state and local governments in coming years. Buffett's muni insurer, Berkshire Hathaway Assurance Corp., has scaled back its activity substantially, guaranteeing only $40 million worth of muni bonds in 2009 compared with nearly $600 million the year before.

Given the severity of the Great Recession compared with prior downturns and the tenuous nature of the recovery, there's little comfort in the argument that muni defaults will remain rare just because they always have. But even though state and local governments continue to struggle through the worst economic climate in decades, many of the specific concerns getting attention in the media appear overblown. Some of the worst news stories involve isolated municipalities that made reckless moves well before the downturn, and many muni researchers can and did anticipate their troubles in advance.

Highlighting the Obvious
Dire straits in Harrisburg, Pa., have made headlines lately, but the foundation for its current predicament was laid back in the early 1990s, when the city agreed to guarantee the debt of an incinerator plant that had been plagued with problems since the 1970s, when it was built. The plant was already burdened with close to $100 million in debt when the Federal government shut it down in 2003 for polluting. At that point, Harrisburg borrowed another $125 million to rebuild it, hoping that it would make enough money collecting trash to eventually pay down the debt. Those revenue projections were far too rosy, however, and now the plant is saddled with almost $300 million in debt that it can't afford to pay off, leaving Harrisburg on the hook. Unfortunately, the $68 million due on the plant's debt this year alone exceeds the city's annual budget by $3 million.

Even though the incinerator plant has created a huge mess for Harrisburg, bondholders may still come out all right. Much of the debt is also backed by surrounding Dauphin County and/or insured by  Assured Guaranty (AGO), the last monoline insurer in strong-enough financial condition to continue backing new bonds. So far, Assured Guaranty has paid principal and interest on bonds with depleted debt service reserves that the county doesn't back.

The Las Vegas Monorail's Chapter 11 bankruptcy petition at the start of 2010 is hardly shocking, either. In a court filing, Las Vegas Monorail Corporation CEO Curtis Myles framed the bankruptcy as a result of the downturn when he indicated that ridership "has not met projections formed prior to the economic collapse." It didn't take a decline in gaming revenues to drag the project under, however. The monorail never came close to reaching the ridership and revenue projections laid out by consultant URS Greiner from the outset. The company projected fare revenue of $50 million in 2005, a target the monorail missed by $20 million. Actual fare revenue hovered around $30 million each year even though initial projections estimated revenue exceeding $60 million in 2009, a target it missed by more than half. Since payments on the debt depended on net revenue left over after operating expenses, muni analysts didn't need to be rocket scientists to see the writing on the wall.

Deficit Crisis, Not a Debt Crisis
For those concerned about a replay of the eurozone's sovereign debt crisis among municipal issuers here at home, the numbers don't add up. State debt burdens, which range from 0% to 7% of gross state product, are still low, and annual debt service as a percentage of budget expenditures ranges from 0% to 13%, or roughly 3% on average, according to the Bureau of Economic Analysis. State lawmakers in California have yet to close a $19 billion budget gap for the current fiscal year, but that doesn't mean its general-obligation bonds are in danger. The state's estimated debt-service payments this year amount to roughly 5% of its budget and rank second only to spending on education. Payments on California's general-obligation bonds are also continuously appropriated, meaning they'll get paid whether lawmakers agree on a budget or not. Sacramento has already demonstrated a willingness to take drastic measures--whether furloughing workers or issuing IOUs--to keep enough cash on hand.

Granted, the numbers look worse if you add in states' unfunded pension obligations. That threat is more long-term than immediate, though, and some states have begun taking the necessary steps toward addressing the shortfall. New York recently modified rules requiring new employees to make annual pension contributions of 3%, for instance. Several unions in California acceded to benefits cuts for the first time in years, and unions in other states have also supported benefits cuts and increased contributions from new workers.

Some commentators have expressed concern that a few state and local governments will lack the political will to make the tough decisions required to balance their budgets and pay off their debt. That hasn't been the case, by and large. State tax revenues are still well below pre-recession levels, but the gap between current tax receipts and expenditures for states and local governments has narrowed considerably over the past two years partly as a result of both service cuts and tax increases, including "sin taxes" on alcohol, tobacco, and gambling. According to Barclays Capital, at least 45 states have cut services to their residents this year while 30 have raised taxes.

States will no doubt push some of the pain down to local governments as they balance their own budgets. A few could face severe financial stress as a result, but the kind of trouble that would impact bondholders should remain few and far between. Some are concerned that one or two bankruptcies could spark a trend, but Chapter 9 bankruptcy doesn't appear to be the cure-all some suppose. Vallejo, Calif., a town that declared bankruptcy in May 2008, has had little luck restructuring its onerous obligations to police and firemen so far, despite spending a costly two years in Chapter 9 protection. That's not an encouraging sign for local governments considering a similar path.

Research and Diversify
It's highly unlikely an avalanche of muni defaults is in the offing, but that doesn't mean it's smooth sailing from here. Many state and local budgets are still under pressure, as one-time budget fixes wear off and the remainder of Federal aid under 2009's American Recovery and Reinvestment Act aid is spent. Some local governments are better positioned than others to withstand cuts at the state level, while areas hard hit by the real estate downturn and aging communities that depend on one or two struggling employers may have a tough time. Nonessential projects such as convention centers or those that depend on state appropriations could find their plug pulled, while poorly positioned hospitals facing stiff competition and a concentrated payer mix could also see trouble.

One of the most important lessons for muni investors to emerge from the credit crisis is that it's critical to differentiate the safe bets from the bad ones through careful research. Before 2007, the pervasiveness of bond insurance rated AAA caused many investors to treat munis as interchangeable. Those who paid scant attention to the underlying issuers' fundamentals suffered a shock when one insurer after another got swept up in a frenzy of downgrades due to their exposure to subprime mortgages.

Don't let the broad rally for credit-sensitive fare in 2009 and early 2010 dupe you into thinking an aggressive, yield-rich fund is well-equipped to handle a rough credit environment, either. Strong gains during this stretch may have masked underlying credit trouble in some cases.  Oppenheimer Rochester National Municipals (ORNAX) topped the high-yield muni pack over the past 12 months with a 30% gain, for instance, thanks to its concentrated exposure to bonds backed by proceeds from the tobacco Master Settlement Agreement (20% of assets), airline bonds (16%), and leverage. At the same time, the fund's exposure to bonds in default came in at just under 5% of assets was in as of January 2010, including a number of Florida land-secured bonds that have missed payments.

The Oppenheimer fund loudly broadcasts its junky profile to shareholders, but problems can crop up in higher-quality funds, too.  USAA Tax-Exempt Long-Term (USTEX) invests mainly in investment-grade bonds, but its second-largest individual holding was issued by the Mashantucket Pequot Tribal Nation in Connecticut, owners of the struggling Foxwoods Resort Casino. Although the bond is still paying principal and interest, the tribe is negotiating a debt restructuring. Most funds are diversified enough to handle a few defaults, but the decision to devote a sizable slice of a portfolio to a dicey credit (3% of assets when the bonds were borderline investment-grade at the end of 2007) should raise red flags for those concerned about muni fundamentals.

Our favorite muni fund shops--including Fidelity, Franklin, T. Rowe Price, and Vanguard--have a long history of conducting in-depth credit research on underlying issuers whether bonds are insured or not. In an encouraging sign, big and small muni-fund shops alike have added to their analyst ranks over the past two years to keep up with the research demands required by today's tough fundamental climate. In 2009, T. Rowe Price rehired veteran Patricia DeFord, who led the firm's muni-research team and comanaged  T. Rowe Price Tax-Free High-Yield (PRFHX) in the 1990s. In 2008, Santa Fe-based Thornburg Investment Management hired Christopher Ryon, former head of Vanguard's long municipal-bond group, as well as an analyst from bond insurer FSA (recently bought by Assured Guaranty) in 2010. Putnam has been one of the few large muni managers to actually cut back on resources during the downturn when it laid off both portfolio manager Brad Libby and a junior team member in 2009.

As the misleading headlines show, there's more to muni-credit research than scanning the morning paper. The argument for keeping your muni exposure broadly diversified and outsourcing the bond-specific research has never been stronger. And when it comes to choosing funds, it still pays to do your homework.