Municipal Budget Woes Return

December is the mid-way point in the fiscal year for states and municipalities. As we approach this milestone, a few recent reports from independent agencies highlighted the opening of new budget deficits for the current 2010 fiscal year. The Washington D.C. based Center on Budget and Policy Priorities reported budget deficits totaling $16 billion have opened up in 26 states. The National Governors Association reported that fi scal conditions deteriorated significantly for states in 2009 and that such conditions would likely persist into 2011 and perhaps 2012. The Nelson A. Rockefeller Institute of Government stated tax collections are likely to remain depressed and may result in budget deficits beyond fiscal 2010.

The news on fiscal 2010 budget deficits was expected even though states closed a combined $73 billion in budget deficits for fiscal year 2009, which ended last June. Newly enacted budgets anticipated a sharp decline in revenue, but states tend to err on the side of being conservative. Raise taxes too high or cut services too much, and states run the risk of hampering the economic growth needed to eventually restore budgets. Full data on revenues collected often came after 2010 budgets were enacted. State tax collections dropped 16% during the second quarter and indicated that 2010 budgets might miss the mark. Furthermore, state finances lag the broader economy by one to two years. With the recession having not ended until mid-2009 at the earliest, budget deficits for 2010 and even 2011 are no surprise.

Municipal Defaults in the Horizon?

While the news on budget deficits was expected, several negative reports surfaced regarding the health of the municipal bond market, which culminated with a prominent New York hedge fund calling for widespread municipal defaults. We believe such reports are greatly exaggerated and not likely representative of what will occur in the municipal market.

Since July 1, roughly $1.7 billion in municipal bonds have defaulted (according to the Municipal Securities Rulemaking Board (MSRB) filings) out of an entire municipal market size of roughly $1.2 trillion, amounting to a very small default rate of 0.14%. That number will likely increase, but it’s important to note that the vast majority of defaults have occurred from lowly rated, or non-rated issuers. So far, housing-related issuers lead default statistics by a wide margin. This is not a surprise, and Florida has so far witnessed four times the number of defaults compared to the next closest state, California, based on the number of issuers defaulting. This also is not a surprise. The bulk of these defaults consist of non-rated land secured financing bond deals that were very speculative in nature to begin with. Defaults among investment-grade rated municipal bonds have been extremely rare thus far.

In addition to the lagged impacts on local economies, a fair amount of political gamesmanship is likely to keep budget headlines negative. The $787 billion stimulus package addresses roughly only one-third of state budget deficits. The bulk of remaining stimulus dollars will be disbursed before year end 2010, meaning that state politicians will likely highlight weaker financials in an attempt to obtain another round of Federal funding for 2011. State officials will likely cite the negative impacts to local economies and employment, and its related impact on the national economy, if additional funds are not received.

Pensions are an Issue

In addition to budget issues, recent negative reports have cited impending pension and entitlement costs as another sign of pending doom in the municipal market. While pension issues are certainly worth watching, these are long-term liabilities and what is most important to watch is if, or how, pension obligation exceeds the annual debt service costs to finance that future liability. Typically, if a municipality falls behind and pension liability expands, revenues are diverted from infrastructure and local services to fund pension liabilities. This then becomes more of a problem for local/regional economic growth rather than the bondholder. Continuing local projects and services when workers’ pensions are threatened is politically risky and therefore avoided. Furthermore, pensions are also affected by changes to actuarial assumptions, change in workforce demographics, and changes to pension law. Assessing risks from pension liabilities is therefore constantly shifting, usually an issuer-by-issuer situation, and longer-term in nature.

We continue to believe the municipal market will remain resilient to credit challenges. As Moody’s highlighted in a long-term study the cumulative 10-year default rate among investment grade rated municipal bonds amounted to an average of only 0.10% from 1970 to 2006. Municipal bonds issued by the city of New Orleans reflect the resilience of the municipal market. The population of New Orleans fell by almost 50% following Hurricane Katrina yet no New Orleans general obligation (GO) bond defaulted. Many were downgraded to below investment grade but returned to investment grade status within two years.

Consider Revenue or GO Bonds

Individual bond investors who desire another level of safety may wish to focus on essential service revenue bonds instead of GO bonds. Bonds secured by vital services such as sewer systems, toll roads, water systems, and public transportation networks are much less affected, and sometimes immune to the challenges facing state and local government budgets. For municipal mutual fund investors, our recommended managers are actively assessing credit quality of all their holdings.

We do not dismiss the credit challenges facing states and local governments; however, we find reports of widespread defaults or a municipal market collapse as greatly exaggerated. Rating downgrades are to be expected during this difficult period but defaults are likely to be rare for high-quality issues and manageable for the high yield segment. As a result, we find high yield municipals still attractive given the level of risk. We believe a skilled high yield bond manager can reap the higher yield advantages and benefit from an improving economy while avoiding defaults. States have already taken steps to address fiscal challenges with 41 cutting services and 30 raising taxes. These steps are unappealing but help carry states and local governments through tough times until employment and the economy rebounds. States and municipalities have exhibited great flexibility in the past in addressing credit challenges, and we expect them to do so again.

IMPORTANT DISCLOSURES

This was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fi xed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
Mortgage-Backed Securities are subject to credit risk, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
Municipal bonds are subject to availability, price and to market and interest rate risk is sold prior to maturity.
Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax.
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