ORANGE COUNTY IN BANKRUPTCY : Q & A : Do Muni Bond Investors Need to Worry?
The threat of a bankruptcy filing by the County of Orange sent shivers of fear through the municipal bond investment community Tuesday as investors across the nation anxiously called their brokers asking whether their bonds were safe.
Do investors in Orange County bonds need to worry about their principal and interest payments? What would bankruptcy protection mean? Should municipal bond investors everywhere be concerned about costly demons lurking in city, county and state treasuries? What kinds of bonds are the safest? Here are a few questions and answers.
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Q: I have a “tax-free” California Municipal Bond fund. Should I worry?
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A: Probably not. The crisis might affect your fund’s net asset value if Orange County defaults on some of its debts. However, the affected bonds are unlikely to make up a significant portion of the fund’s portfolio. The direct dollar impact, if there is one, will be small. If the market ultimately demands higher interest rates for municipal bonds because of the risk, it will lower the value of current bonds in the portfolio but also increase your return on the new ones added to it.
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Q: I hold individual Orange County bonds. Do I need to worry about whether they will be paid off on time?
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A: That depends on what types of bonds you hold. Certain types are at far greater risk of default than others, says Zane Mann, publisher of the California Municipal Bond Advisor in Palm Springs.
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Q: How many types of bonds are there? And why would some be at greater risk than others?
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A: There are essentially five different types of bonds that are differentiated by funding source. General obligation bonds are backed by the full faith and taxing authority of the issuer. Revenue bonds are paid through the revenue of the issuing entity, which is often a utility. Redevelopment bonds pay principal and interest from new tax revenues from redevelopment areas. Mello-Roos bonds, also called “dirt bonds,” are financed through real estate taxes in specific geographic areas. And certificates of participation allow bondholders to participate in lease payments made to the issuer.
While any of these kinds of bonds can be at risk when the issuer is insolvent, COPs pose particular risks because annual debt service payments must be included in county budgets and appropriated annually by the county board of supervisors. Now that Orange County has declared bankruptcy, the appropriation to pay on these bonds could be nixed.
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Q: Does that mean all the other types of bonds are safe?
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A: That’s unclear. Many experts believe that Orange County is financially healthy but temporarily short of cash. If that’s the case, principal and interest payments on the county’s bonds could be delayed but are probably not at risk. However, if the county is in worse shape than currently believed, it will depend on the bond’s revenue source and whether that source of revenue can be tapped to pay bills rather than bondholders.
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Q: What about bond insurance? Aren’t some of these bonds privately insured? Won’t the insurer step in to make payments if the issuer defaults?
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A: Yes. A number of the bonds are privately insured by the likes of AMBAC Indemnity Corp. and Municipal Bond Investors Assurance Corp. These companies will make principal and interest payments if the bond issuer defaults. Investors should have no interruptions in their payments, says Michael C. Bellinger, vice president of MBIA in Armonk, N.Y.
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Q: Which bonds are insured?
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A: There is no definitive list, partly because insurance can be purchased by the issuer or through the secondary market. Some bonds that were originally issued without insurance were purchased by investment companies that then bought insurance and resold the bonds.
The good news is that bond insurance is generally purchased by the riskiest issuers.
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Q: How do I know if a municipality is doing something risky with bond proceeds?
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A: There’s no good answer, says Dave Herships, senior municipal bond analyst at Kemper Securities in Chicago. While it’s rare for municipal treasurers to take great risks with county funds, it does sometimes happen. And often the danger signs are invisible, he says.
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Q: What should I do with my Orange County bonds now?
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A: Nothing. Investors should quell any urge they have to bail out, experts maintain. Until Orange County’s financial picture is clarified, the market for these bonds is nil.
“It is important to stem any urge to panic,” says Bradford N. Langs, senior bond analyst at Kemper. “The risk of the county not being able to pay is very small.”
