The worst economic downturn since the Great Depression has forced many state and local government budgets into a widely publicized vise.
What exactly does that vise mean for bondholders? Not as much as a lot of people think, many analysts say.
Analysts and municipal strategists say the headlines about budget gaps exaggerate their influence on credit quality.
While governments may have to cut costs, raise taxes, or tap reserves, analysts say the hype about large-scale municipal government defaults is overblown.
“A number of commentators have emerged forecasting widespread defaults in the muni market,” Phil Fischer, muni strategist at Bank of America Merrill Lynch, wrote in a report last week. “After the Panic of 2008, we are acutely aware of the fat-tailed world we live in where extreme outcomes are possible. Nevertheless, Pollyannas are out, as are doomsday scenarios.”
Even so, such luminous names as New York Lieut. Gov. Richard Ravitch and hedge fund manager James Chanos have slammed municipal credit this month.
Chanos outlined numerous arguments against local government credit in Barron’s this week. Governments have rung up hefty pension liabilities and “platinum-plated” health care costs, he said, and they dissemble the erosion in their true fiscal health with accounting gimmickry.
States face a total of $350 billion in budget gaps this year and next, according to the Center on Budget and Policy Priorities.
Tax receipts by state and local governments plunged 12.2% in the second quarter from the second quarter of 2008, according to the Census Bureau, the steepest plunge in at least 20 years. Income taxes were particularly weak, sinking 27% over the same period.
The most obvious rejoinder to the worries over defaults is municipalities’ stellar credit history.
The cumulative default rate on municipals rated investment grade by Standard & Poor’s is 0.2%. Municipals rated investment grade by Moody’s Investors Service fared even better, with a default rate of 0.07%. As Chanos pointed out, though, just because it hasn’t happened yet doesn’t mean it won’t. After all, markets endured plenty of unprecedented or previously rare travails last year.
Besides, the default rates may not show how municipalities would perform several years into an economic contraction. George Hempel’s seminal 1971 study, “The Postwar Quality of State and Local Debt,” found municipalities defaulted en masse in the latter stages of the Great Depression.
He discovered 4,770 defaults from 1929 to 1937, representing more than 16% of outstanding municipal debt.
Fischer does not think much of the parallels between the Great Depression and today. The sheer magnitude of the Depression negates the similarities, he said. Furthermore, economists and policy-makers are more sophisticated now and better equipped to mitigate financial crises, Fischer said.
George Friedlander, municipal strategist at Morgan Stanley Smith Barney, in a report last week listed a multitude of reasons he thinks state and local government defaults will remain rare.
Chief among the reasons municipalities will continue repaying their debt, according to Friedlander, is that they have to.
Governments know they need to borrow regularly and cannot afford to repulse investors by defaulting on bonds, he said.
Aside from losing access to the capital markets, filing for Chapter 9 bankruptcy is not an easy way out, anyway. It can be a difficult process that does not ease the debt burden after all, he noted.
Moreover, repaying debt normally does not impose a big cost on municipalities, Friedlander said. According to a Citigroup study, paying off debt represented only 8% of revenue at the state level.
Friedlander doubts any state would be so irresponsible as to allow a deficit to interfere with servicing debt.
“Suggestions that the municipal bond market will be the scene of widespread disruptions in debt repayment are, in our view, greatly overstated,” he said. “We certainly do not agree that many of the conclusions about eroding credit quality are accurate, consistent, or even relevant.”
Fischer and Friedlander both acknowledged government finances will continue to be squeezed.
Friedlander cautioned about the risk of downgrades and scary headlines sending bond prices on a more volatile path. That is a different story altogether from defaults.
Fischer also noted that the increased incidence of defaults among nonrated bonds is “true and to be expected.”
“Rational behavior demands that issuers who expect very low ratings would not pay to receive them,” he said. “This is the basic rationale for our advice that investors avoid unrated bonds unless they are intimately familiar with a specific credit.”
Defaults on rated bonds remain “quite rare,” Fischer said.
The hand-wringing over municipal credit is good news for at least one person — Mitchell Savader, chief executive of Savader Asset Advisors.
Savader’s firm, which performs credit research for asset managers, has seen an uptick in business as people worry about credit and defaults in the post-bond-insurance era, he said.
Savader says to expect a few hundred defaults in the next one to two years, but mostly among smaller, less traditional issuers and rarely from government bodies.
“I’m sure there will be some [governments] that find themselves in severe difficulty, but usually that severity can be dealt with through what might be unpopular moves,” he said. “It doesn’t mean there won’t be some defaults, but the issue will be more one of a declining value of the bonds rather than outright default among many issuers.”
Savader looks for more defaults in land-backed deals and special-purpose districts.
Many of the default filings these days have been from community development districts in Florida, including at least two last week.
According to Municipal Market Advisors, bonds with $1.72 billion in par value have defaulted since July 1, with the most errant sectors in housing, retirement communities, and hotels and casinos.
A typical example of an issue Savader considers at risk of default is the Crown Development Projects-Prairie Ridge East in Kane County, Ill., about 50 miles south of Chicago.
The village of Hampshire issued $25.2 million to finance the construction of the development, which is a parcel in a planned residential community. The bond is secured by taxes paid by people who own the properties in the development.
The problem is nobody has moved in yet, meaning all the taxes are owed by the developer that built the property, Hampshire West LLC.
Since the credit quality of the bond is essentially the credit quality of Hampshire West, Savader considers the issue’s security “speculative.”
That is the type of sector where Savader looks for defaults. Governments with unlimited taxing power are in a different category, he said.
Referring to municipal defaults, Savader said: “From a bondholder perspective, it’s still going to be a small number.”
