Municipal Bonds

The Rising Risks In Municipal Bonds

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This article originally appeared on ETF.COM here.

While I could provide an almost endless list of forecasts that went wrong from so-called experts, among the most infamous was surely Meredith Whitney’s December 2010 forecast of between 50 and 100 “significant” municipal bond defaults, totaling “hundreds of billions of dollars.” In March 2011, noted economist Noriel Roubini jumped on Ms. Whitney’s bandwagon, predicting $100 billion in defaults over the next five years. Such forecasts led to massive withdrawals from municipal bond mutual funds.

The massive scale of problems that Whitney and Roubini anticipated didn’t occur because many (though far from all) governments took actions to address the problem, cutting spending and raising revenues.

However, investing in municipal bonds is riskier than many investors may perceive, with last year’s $74 billion default by Puerto Rico providing a reminder. There have been other significant ones in recent years, including Jefferson County, Alabama ($4 billion); Stockton, San Bernardino and Vallejo, California; Harrisburg (the capital of Pennsylvania); Central Falls, Rhode Island; and Detroit ($18 billion).

Unfortunately, municipal bond investing is getting riskier as the financial conditions of a significant number of states and cities have deteriorated. And while defaults are still relatively rare, municipalities are defaulting at an increasing rate. According to U.S. News & World Report, almost 44% of the defaults Moody’s Investor Service recorded between 1970 and 2016 occurred since 2007.

As the number of bankruptcy filings increased, the “taboo” against bankruptcy has likely weakened – rather than cut services, distressed governments might default, especially since pension benefits are difficult to cut (and may, in some cases, be constitutionally protected by state law).

Two important ratios

Investors need to be careful to not only look at a government’s funding ratio on its pension obligations (as reported by Standard & Poor’s) but also the adjusted net pension liabilities (ANPL) as a percent of revenue (as reported by Moody’s), which is a truer reflection of its financial situation, because it is based on more realistic forecasts of returns. Unfortunately, states can set their own rate of return assumptions.

In their October 2018 report, “U.S. State Pensions Struggle For Gains Amid Market Shifts And Demographic Headwinds,” Standard and Poor’s reported that the rate of return assumptions across state public pension plans averaged 7.3% for fiscal 2019. Given historically high U.S. equity valuations (forecasting lower future returns), and with bond yields still well below their historical averages, it’s not prudent to rely on a return assumption that high. That’s why Moody’s uses its own assumptions based on current valuations.

In August 2018, Moody’s reported that the majority of U.S. states experienced a sharp increase in their ANPL in fiscal year 2017. “Fiscal 2017 reporting shows total state ANPL at $1.6 trillion, or 147.4% of state revenue, up significantly from $1.3 trillion and 122%, respectively, in fiscal 2016,” a Moody’s analyst wrote.

Risks increasing

The bottom line is that risks to municipal bond investors is increasing. That means it is becoming more important to focus on credit quality. And because the main role of fixed income in a portfolio should be to dampen the risk of the overall portfolio, investors should limit their investments in municipal bonds to only bonds that are rated AAA or AA (rated A for maturities of under three years).

In addition, regardless of the rating, investments should be in only the two safest types of bonds: general obligation bonds (GOs) and essential service revenue bonds (such as water and sewer). The table below shows why this should be the case. It is from a Moody’s study covering the period 1970 through 2016.

Municipal Bonds

Read the full article here by Larry Swedroe, Advisor Perspectives

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