Last week, the city of Harrisburg, Pa., was thrown into bankruptcy.
How did this happen? As with most people who simply can’t handle their finances, the city accrued so much debt that it was no longer even able to afford the interest payments.
Harrisburg isn’t alone. Thousands of cities are moving in the same direction. Stockton, Calif., announced that it may default on redevelopment agency debt it issued in 2005.
Municipal bonds, a fixed-income security that offers investors a break on state (and sometimes federal) taxes, have usually been seen as a safe investment vehicle. While they tend to have lower yields than other bonds, this tax break often leads to a return adjusted for the effects of taxes.
Today, safety is not the case. There’s the potential for hundreds of billions of dollars’ worth of muni-bonds to default.
When a company goes bankrupt, the shareholders get zilch, but at least customers have somewhere else to go. When a municipality goes bankrupt, it means local jobs, such as firefighters and police get slashed. City services go. And bondholders take a hit.
Not all cities facing a crisis will default. Instead, they’ll cut services and employees. The city of Vallejo, Calif., declared bankruptcy in 2008.
Earlier this year, it officially exited its bankruptcy. But the core problem wasn’t the number of employees or the services that it offered to its residents.
It was the simple fact that more than 80 percent of the city’s budget went to salaries and benefits, particularly lavish pension benefits, to its employees. The city had the opportunity to make major changes to its pension plan, but didn’t.
In Maine, Pennsylvania, Indiana and Michigan, rural roads are being allowed to turn to gravel. In lieu of outright muni-bond defaults, that’s what we get instead. So don’t call it a default, call it an implosion.
Ultimately, muni-bonds fall into two groups. The first group is the rated group. Yes, it’s rated by the same folks that over-rated housing debt. But this group has an incredibly low rate of defaults relative to unrated muni-bonds.
In that second category, you’ll find all sorts of bonds for projects that a responsible community wouldn’t undertake to begin with.
Muni-bond investors today should carefully review their holdings to determine what will happen if the underlying municipality defaults. With over $3 trillion at stake in the muni-bond market, even a few defaults could investors cowering for the safety of cash.
That’s not to say all muni-bonds are a terrible investment. Most will be fine. Look for solid credit ratings and a healthy payout ratio relative to the municipality’s revenues.
If all else fails, look for areas with healthier finances overseas, where you’ll likely find better financials and higher yields.
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