Investors face their fears in muni debt
Harvey Kauffman isn’t looking for excitement in his investment portfolio. So the retired La Costa septuagenarian has almost all of his savings in bonds -- including California tax-free municipal issues.
Suddenly, he’s got exactly the kind of excitement he didn’t want: With the state facing an unprecedented budget shortfall, Kauffman has been left to wonder whether his bonds will pay interest and principal as promised.
“I’m really concerned,” he says. “Since I’m retired, I don’t have any way to replace it if I lose it.”
But for now, Kauffman is holding tight: “I’m believing that everything will be OK.”
That faith has prevailed in the California municipal bond market despite the dire headlines of the last few weeks. There is no sign that institutional or individual investors have been bailing out of munis.
Their willingness to stay put shows in the rising or steady share prices of mutual funds that own debt of the state and its cities, counties and other municipalities. The market value of many of those portfolios rose this week even after voters rejected ballot measures that might have eased the state’s fiscal crisis.
“What the market is telling us is that long-term investors believe [California] is going to figure out how to pay its debts,” said John Carbone, manager of the Vanguard California Long-Term Tax-Exempt fund.
Then again, the market has been blindsided by one financial catastrophe after another over the last 18 months or so. It seems inconceivable that California won’t make good on its debts, but the failures of Fannie Mae, Freddie Mac, Lehman Bros. and General Motors Corp. also were inconceivable to plenty of Americans.
Muni bond fund managers prefer to point to history: Defaults have been rare events in the modern era. Studies typically have found that the annual default rate has averaged a sliver of 1% of outstanding bonds since World War II.
Still, there have been some shocking muni busts, such as the West Virginia Turnpike in 1958 and the Washington Public Power Supply System (nicknamed Whoops) in 1983.
If we go back to the Great Depression years, the picture darkens noticeably. The average annual default rate was 1.8% of outstanding muni debt from 1929 to 1937, according to study by David Blair, a muni expert at bond fund giant Pimco in Newport Beach.
Detroit, Cleveland and government units of Buffalo, Chicago and Miami were among the high-profile defaults of the Depression years, Blair said. Among the states, Arkansas also temporarily defaulted on its debts.
California Treasurer Bill Lockyer has insisted, over and over, that short of “thermonuclear war,” the Golden State won’t join the list of prominent deadbeats.
As he points out, repayment of the state’s general obligation bonds -- debt issued to finance infrastructure projects -- has an iron-clad guarantee in the state Constitution. Bond payments are subordinate only to the education portion of the budget.
Other types of state debt don’t have that same degree of legal protection, however. That includes the $10 billion or more of short-term debt that Lockyer will be forced to try to issue this summer to bridge the gap between the state’s current cash needs and future tax revenue.
Fearing that investors either wouldn’t buy that debt or would demand exorbitant interest rates, Lockyer for months has been seeking a federal backstop on the securities to give investors more comfort. But on Friday he told the Legislature that the Obama administration was unlikely to provide a backstop.
The state may well keep paying its debtholders on time and in full, as Lockyer promises. But the massive budget cuts facing Sacramento will filter down to cause extreme financial pain for cities, counties and other local government entities -- many of which have their own debt payments to worry about.
Even before the depths of California’s financial crisis became evident, credit-rating firm Moody’s Investors Service in April issued a blanket warning about the budget risks confronting local governments nationwide.
“This negative outlook reflects the significant fiscal challenges local governments face as a result of the housing market collapse, dislocations in the financial markets and a recession that is broader and deeper than any recent downturn,” Moody’s said.
Still, it’s a fair assumption that the vast majority of muni bonds will pay off as promised, Pimco’s Blair notes. And even when defaults occur, investors tend to recover most of what they are owed over time, he said.
The key risk to most muni investors, then, isn’t credit risk, but market risk: the potential for interest rates to rise on new bonds, devaluing older bonds issued at lower rates.
If you’re betting that there will be enough headline-grabbing credit crises in the muni market over the next few years to spook investors into demanding higher yields to compensate, it would make sense to keep some powder dry for better opportunities.
Marilyn Cohen, a veteran bond investor who heads Envision Capital Management in Los Angeles, notes that the muni market suffered a blistering sell-off last fall amid the financial-system meltdown. Long-term muni bond yields reached their highest levels in 14 years as some investors fled.
But yields quickly tumbled this year as fear receded. That fast recovery is helping to keep many muni investors sitting on their hands now even as California’s troubles worsen, Cohen said. “People sold last fall and then saw the market bounce back,” she said. Investors don’t want to take the chance of being whipsawed like that by selling now, she said.
Even though muni yields have dropped from last year’s peaks, they’re still historically high compared with yields on other bonds, such as U.S. Treasuries. A 10-year California general obligation bond yields about 4.4% -- free of federal and state income tax -- compared with 3.4% for a 10-year Treasury note, which is federally taxable.
For now, many muni investors figure they’re being adequately paid for the risks. The question is, do we know a lot less about those risks than we think we do?
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