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 In 2010, industry analysts warned of a looming fiscal crisis among state and local governments. Some experts even predicted widespread municipal bond defaults in the US.1 Investor fears intensified in late 2010 when the municipal bond market experienced one of its largest selloffs in decades.
Is the municipal bond market at risk for widespread default? Before you attempt to answer this, consider these principles:
The municipal bond market is large and diverse. The media often report on municipal bond problems as though the market is a single, uniform sector. In reality, the market comprises an estimated $3 trillion in debt, with about 55,000 state and local issuers and approximately 2 million outstanding issues. These bonds are rated across a broad spectrum of credit categories and have different characteristics and structures for paying their obligations. Such complexity does not afford simple observations about the market.
Historical default rates are low. Muni bonds have a strong track record of repayment. One reason is that state and local governments are motivated to avoid default since failure to pay affects their ability to raise capital in the future. Another reason is that most issues repay investors from either project revenues or from a general fund backed by the taxing power of the issuer. (Of course these historical default rates may not be so low in the future, especially if fiscal conditions prove worse than in the past.)
Most fiscal problems are reportedly concentrated in a few large states. An estimated 58% of the recent budget shortfalls have occurred in five states: Arizona, California, Illinois, New York, and Texas.2 Moreover, current levels of state and local government debt, as well as interest payments on that debt, remain well within the historical range.3 However, beyond the short-term budget gaps, many local and state governments face deep structural problems, including unfunded pension liabilities that could consume a growing share of their budgets. Research estimates that these pension obligations may be considerably higher than what states are reporting.4 Municipal bonds are assessed according to actual financials, not models or projections. Some reports have compared the municipal bond market to the subprime mortgage securities market prior to the financial crisis but the circumstances are different in some ways. Municipal bonds are not exotic instruments with complex structures that obscure the underlying credit rating and market value of the assets.5 As a result, munis are generally more transparent than the mortgage derivatives that helped spark the financial crisis. Also, state and local issuers are subject to financial disclosure rules, and the information they provide affects the market prices and credit ratings of their bonds. Still, lawmakers are pushing for improved accounting standards and reporting rules to increase transparency for investors and market participants.6 Fixed Income And Your Milestone Portfolio Milestone accounts which contain diversified fixed income products are allocated to manage risk. Here are a few guiding principles currently in use:
Hold shorter-term issues. This approach may help reduce volatility while enhancing liquidity.
Maintain broad diversified. Holding many municipal bond issues and avoiding concentration in a particular state, sector, or issue type can help reduce the impact of a few non-performing bonds. If default rates rise, investors with a well-diversified municipal portfolio should be less exposed. Focus on quality and use market pricing to confirm credit ratings. The most creditworthy bonds are those rated AAA or AA, and most of the current problems involve lower-rated bonds. Focus primarily on municipal bond mutual funds rather than individual muni bonds. Although building a portfolio of individual bonds offers more control over maturity, face value and bond type,achieving broad diversification may prove a challenge, and the portfolio may be less liquid and expensive to trade, and require more attention and oversight than is feasible or practical. Mutual funds are used for many reasons, including enhanced diversification at a reasonable cost and better liquidity. As we have seen over the past six months, share values of the municipal bond funds used in Milestone portfolios have held their value in spite of analyst warnings and increased redemptions across the asset class. One reason for this is that the fund primarily used -- the DFA National Short Duration Muni Fund -- generally does not engage in market timing, nor for that matter do the advisors who use the funds in their practices. This lends itself to such stability, and thus reduces the temptation to re-allocate a portfolio away from the investment policy guidelines that your portfolio is built around.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks as well, including changes in credit quality, market valuations, liquidity, prepayments, early redemption and other factors. This article is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security or services.
End Notes: 1. Shawn Tully, "Meredith Whitney's new target: The states," CNNMoney.com, Sept. 28, 2010. 2. Randall Forsyth, "The Sky Isn't Falling on the Muni Market," Barrons.com, January 7, 2011. 3. Iris J. Lav and Elizabeth McNichol, "Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm," Center on Budget and Policy Priorities, Jan. 20, 2011. 4. Robert Novy-Marx and Joshua Rauh, "Public Pension Promises: How Big Are They and What Are They Worth?" Journal of Finance (forthcoming). 5. Agnes T. Crane, "States' Troubles Are Not the Real Risk for Muni Bonds," New York Times, Jan. 30, 2011. Also see Randall W. Forsyth, "Man Bites Dog in the Muni Market," Barrons.com, Feb. 1, 2011. 6. Andrew Ackerman. "SEC Could Gain Authority to Regulate Muni Disclosure," Wall Street Journal, April 13, 2011. The SEC indirectly regulates municipal market disclosures through the banks and broker/dealers that underwrite municipal securities. Under current SEC rules, dealers cannot underwrite municipal bonds unless the issuer has agreed to provide annual audited financial reports and to notify the market of certain events, such as a change in credit rating. |
