The most recent drama brought to us by the news media has been the risk of municipal bond issuers defaulting on their debt obligations.
We and other professional investors in municipal bonds have been aware of and monitoring the heightened municipal bond default risk for nearly three years. However, it took a segment on 60 Minutes featuring the photogenic, publicity-minded banking analyst, and newly-minted municipal bond expert Meredith Whitney to really light up the airwaves on this issue.
Whitney predicted: “Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars’ worth of defaults.”
The one-year record for municipal defaults (2008) was just over $8 billion. So, Whitney’s prediction of “hundreds of billions” would be at minimum a 2,400% increase in the rate of municipal defaults. If she is wrong even by a factor of ten; however, it would still be a very bad year for municipal defaults.
We believe that there are serious deficit and debt problems in many cities, counties, and states across the country. We also believe that the relative risk of municipal defaults is, indeed, as high as it’s been in a long time. In this case, however, the word “relative” is critical. Let’s set the context for that higher relative risk with some data:
We and other professional investors in municipal bonds have been aware of and monitoring the heightened municipal bond default risk for nearly three years. However, it took a segment on 60 Minutes featuring the photogenic, publicity-minded banking analyst, and newly-minted municipal bond expert Meredith Whitney to really light up the airwaves on this issue.
Whitney predicted: “Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars’ worth of defaults.”
The one-year record for municipal defaults (2008) was just over $8 billion. So, Whitney’s prediction of “hundreds of billions” would be at minimum a 2,400% increase in the rate of municipal defaults. If she is wrong even by a factor of ten; however, it would still be a very bad year for municipal defaults.
We believe that there are serious deficit and debt problems in many cities, counties, and states across the country. We also believe that the relative risk of municipal defaults is, indeed, as high as it’s been in a long time. In this case, however, the word “relative” is critical. Let’s set the context for that higher relative risk with some data:
· Since 1930 Moody’s has recorded nearly 2,000 defaults by non-financial major corporations.
· In stark contrast, since 1930 zero states have defaulted on their debts.
· The largest municipal bankruptcy in history – Orange County, California in 1994 – was just $1.6 billion. (More on that later.) “Hundreds of billions” in defaults would mean over 125 Orange Counties declaring bankruptcy and defaulting.
· Since, 1970, municipal defaults have averaged just over one per year. Multiply that tenfold, and Whitney’s estimate is still nearly 1,000% larger.
· A Moody’s study covering 1970 – 2000 counted just 18 municipal defaults, ten of which were not-for-profit hospitals.
· During that same 30 years, zero general obligation (tax-backed) bonds defaulted
Even if a municipal bond issuer actually does default, however, all is likely not lost. In fact, most is likely not lost. The average recovery rate on defaulted municipal bonds has been 66%. That infamous Orange County bankruptcy? They did not default on their bonds at all. The county cut services, raised taxes, and fully paid the $1.6 billion owed their bondholders. In this case and many others, bankruptcy is not a direct route to loss. It allows the municipality time to correct their mistakes and right size their revenues and expenses.
But all that is history. A recession, housing value collapse (think property taxes), credit crisis, and persistent near-10% unemployment all combine to cause real trouble for many states and municipalities across the nation. Also state Medicaid costs, unemployment compensation, and other social support costs all got bigger, not smaller, during this recession. So, Ms. Whitney is accurate in saying that today’s municipal bond market is not the sleepy, low risk market that most of us have come to know and trust over the years.
Yet we come back to the word relative in rebuttal to Ms. Whitney. Yes, there is more risk in today’s municipal bond market. But as we will show, it is a long way from more relative risk in municipal bonds to the long list of defaults Ms. Whitney is forecasting.
To better explain why we don’t see higher relative risk as meaning high absolute risk, review the following list of things states and municipalities can do that corporations cannot. Each serves to lower the absolute risk of municipal default:
But all that is history. A recession, housing value collapse (think property taxes), credit crisis, and persistent near-10% unemployment all combine to cause real trouble for many states and municipalities across the nation. Also state Medicaid costs, unemployment compensation, and other social support costs all got bigger, not smaller, during this recession. So, Ms. Whitney is accurate in saying that today’s municipal bond market is not the sleepy, low risk market that most of us have come to know and trust over the years.
Yet we come back to the word relative in rebuttal to Ms. Whitney. Yes, there is more risk in today’s municipal bond market. But as we will show, it is a long way from more relative risk in municipal bonds to the long list of defaults Ms. Whitney is forecasting.
To better explain why we don’t see higher relative risk as meaning high absolute risk, review the following list of things states and municipalities can do that corporations cannot. Each serves to lower the absolute risk of municipal default:
· Municipalities have far more capacity to increase revenues than do companies.
· The size of the problem relative to revenue capacity is small. For example, in Illinois, possibly the sickest state, just a 2% increase in state income tax rate would totally eliminate the state’s budget deficit.
· Municipalities can cut costs without reducing their revenues. Labor costs are the largest expense for most municipalities. They can, and many have, reduced headcount and instituted unpaid furloughs.
· In many, maybe most cases, municipalities are legally required to give the highest priority to debt service payments. The first tax dollar pays bondholders, not the last.
· Municipal annual budget deficits are actually getting smaller, not larger, due to an improving economy and cost-cutting.
The list is much longer, but we’ll stop there. Bottom line: The risk of municipal default is higher than the norm of the past 70 years. But, history and the factors just described show us that municipal bonds are far less risky than corporate bonds. That is the reason that the average credit rating of all municipal bonds is near AA, while the average rating for corporate debt is at least a letter grade lower.
There are still municipalities out there that are very bad credit risks. And, Ms. Whitney rightly says there is more risk in municipal bonds today than there has been over the last 70 years.
That being said, we do not agree with her forecast of imminent huge losses in municipal bonds. Indeed, we believe that few high quality municipalities will file bankruptcy and even fewer will actually default on their bonds.
Ms. Whitney’s 60 Minutes appearance has had the effect of shouting fire in a crowed room. Many people have panicked and sold bonds indiscriminately. As most of you know, during the past few weeks we have been buyers of selected municipal bond issues by municipalities and states that our research has shown to be low credit risks.
Our optimism about the prospects for municipal bonds is shared by most of the investment research firms that we have counted on for many years. Indeed, we note that the Pimco bond king, Bill Gross, is said to be buying municipal bonds for his personal account.
The judgment of a life-long professional bond investor putting his own money behind his opinion is to us the best evidence that the current drama is actually a buying opportunity.
Sources: Bloomberg BMO Capital, BCA Research, Moody's
There are still municipalities out there that are very bad credit risks. And, Ms. Whitney rightly says there is more risk in municipal bonds today than there has been over the last 70 years.
That being said, we do not agree with her forecast of imminent huge losses in municipal bonds. Indeed, we believe that few high quality municipalities will file bankruptcy and even fewer will actually default on their bonds.
Ms. Whitney’s 60 Minutes appearance has had the effect of shouting fire in a crowed room. Many people have panicked and sold bonds indiscriminately. As most of you know, during the past few weeks we have been buyers of selected municipal bond issues by municipalities and states that our research has shown to be low credit risks.
Our optimism about the prospects for municipal bonds is shared by most of the investment research firms that we have counted on for many years. Indeed, we note that the Pimco bond king, Bill Gross, is said to be buying municipal bonds for his personal account.
The judgment of a life-long professional bond investor putting his own money behind his opinion is to us the best evidence that the current drama is actually a buying opportunity.
Sources: Bloomberg BMO Capital, BCA Research, Moody's
