Why U.S. munis bond holders are not to worry

NEW YORK | Last November, the U.S. dealt with their biggest municipal bankruptcy in their history: Alabama’s Jefferson County, on the south of the Appalachians, filed for the so-called Chapter 9 after government officials and creditors (among them are JPMorgan and Bank of America) failed to set an agreement on the more than $3 billion in sewer debt.

Jefferson county is not alone. More municipalities have been suffocated by debt since 2007. In some cases like in New York and Pennsylvania, state governments intervened to prevent municipal fiscal meltdowns. As a result, Moody’s has a negative credit outlook for U.S states and local governments as a group.

Why has this happened? Local governments have two major sources of revenue:  income taxes and property taxes, both of which have been hit by the downturn and the collapse of the real estate sector. Besides, municipalities need to pay Medicaid, employee health care and pension costs. The stimulus given by the federal government is not infinite and fiscal problems will put additional pressure on them.

Many analysts have been wondering how this could affect to municipal bond  (munis) holders. Munis are a staple of many fixed-income portfolios. They typically yield 10% to 15% less than Treasuries but their main charm is that they are free from federal taxes. Experts admit that very few muni issuers have taken their troubles out on them. Some states are doing everything they can to avoid defaulting on their bonds, raising local taxes or slashing jobs to cut costs.

The situation is not as dramatic as some had put it (banking analyst Meredith Whitney, who predicted “hundreds of billions” of dollars of failures of cities and towns in 2010, is now facing a credibility issue). Municipal debt has returned 2.7 percent in 2012, more than double the gain for the same periods the past two years, according to Bank of America Merrill Lynch. Defaults reached about $1.3 billion last quarter, up from $531 million in the same period last year, explained Richard Lehmann, publisher of the Distressed Debt Securities newsletter.

“The bulk of the municipal market remains fundamentally very strong,” said Peter Hayes, a managing director of New York-based BlackRock, which oversees about $105 billion of municipal bonds, to Bloomberg radio.

Muni bonds for which payments were missed represented about 0.5 percent of total issuance this year through March 28, according to John Hallacy, head of muni research at Bank of America Merrill Lynch.

The thing to worry about is not the possibility of default, but the shortage of the bonds themselves. As Smart Money’s Elizabeth O’Brien puts it:

“States and municipalities sold $295 billion worth of long-term bonds last year — a big-sounding number, but nearly a third less than they issued in 2010, according to The Bond Buyer, a trade publication that tracks sales. Local governments, worried about their existing finances, are putting off building new schools or other big-ticket projects. Fewer projects means fewer new municipal bonds, and investors are having a hard time finding any debt — from anywhere — to buy.”