Municipal bonds remain solid despite headlines
March 17, 2014
Municipal bond investors have already "priced in" Puerto Rico's cash crunch and Detroit's bankruptcy problems, but both situations bear close watching to see if they set any precedent for other distressed issuers, a Vanguard municipal bond expert said.
Despite these high-profile cases, municipal bonds overall should experience few defaults, and they remain attractively priced compared with taxable bonds, said Christopher Alwine, head of Vanguard Municipal Bond Group. Investors and financial advisors should feel comfortable keeping munis in their portfolios, he said.
Puerto Rico: No surprises
Many municipal bond investors were not surprised in February when Standard & Poor's and Moody's Investors Service downgraded Puerto Rico's bonds to junk status, Mr. Alwine said, as the territory's financial problems have been widely known since last summer. Puerto Rico's general obligation bonds now yield about 8.5% a year, and some trade for three-quarters off face value in anticipation that write-downs may be needed, Mr. Alwine said.
"Puerto Rico's bonds have traded hands into buyers who are comfortable bearing that risk," Mr. Alwine said. "Contrary to conventional wisdom, Puerto Rico bonds rallied after the recent downgrade. We have seen no bleed over into the general municipal market. Municipal valuations today are relatively cheap to taxable alternatives."
Puerto Rico announced February 18 that it would sell about $3 billion in general obligation bonds to meet current payments and other cash needs. But even as Puerto Rico buys more time, the commonwealth may eventually have to restructure its debt and pension obligations, Mr. Alwine said. Still, Puerto Rico bond prices rose on the expectation that the new issue will be met with strong demand in the market.
Although credit problems with Puerto Rico bonds are getting media attention, the market has already factored in the risk.
Detroit's issues bear watching to see if any legal precedent is set.
Municipal bonds remain attractively priced, and whatever the outcome in Puerto Rico, Detroit, or other isolated cases, default rates are expected to remain low.
Although U.S. territories such as Puerto Rico have no legal path to bankruptcy, Congress could create such a mechanism, Mr. Alwine said. According to S&P, Puerto Rico owed $38.4 billion in tax-supported debt on June 30, 2013, or $10,635 per person. The commonwealth also carries $25.6 billion in revenue debt and $37 billion in unfunded pension liabilities.
Mr. Alwine said he did not expect the federal government to fully rescue Puerto Rico, which has become the third-largest issuer of municipal bonds in the country, because other issuers facing large pension and debt obligations would look for the same treatment. But, Mr. Alwine said, there will likely be small-scale U.S. aid through existing programs.
"If they were to bail out Puerto Rico, they might have other issuers requesting a bailout right behind them," Mr. Alwine said. "The federal government would have a role, if it came to restructuring Puerto Rico's bonds, but our expectation is it will not be: 'Let's write a big check to take care of this problem.'"
Puerto Rico's holdings have been popular in some municipal bond funds because they are tax-exempt in all 50 states. Vanguard has underweighted Puerto Rico bonds, but current prices may present a buying opportunity, Mr. Alwine said.
"If they can pay their debts and right their ship, these bonds will be a home run, because they will recover," Mr. Alwine said.
Detroit: Legal precedent important
In Detroit, the big question now is how much bondholders stand to lose, Mr. Alwine said. The city filed its debt-adjustment plan with the U.S. Bankruptcy Court on February 21. The plan calls for police and fire pensioners to get 90% of what they are owed, while general public employees would get about two-thirds. Meanwhile, bondholders would see as little as 20 cents on the dollar. The city's emergency manager, Kevyn D. Orr, wants to classify some general obligation debt as unsecured, and creditors are fighting the move. Mr. Alwine said he was concerned the final legal settlement could create a precedent that pensioners hold higher legal standing than general obligation bondholders, who typically enjoy strong legal protections.
"We're in a different era if the court sets the priority of protecting, or vastly limiting the write-down to, pensioners," Mr. Alwine said. "A lot of the adjustment would then fall on the bondholders. If the courts establish that as the norm, the market will need to demand higher interest rates, to compensate for greater risk, from issuers in weaker financial condition with pension challenges."
Yet even if that occurred, Mr. Alwine said, the municipal bond market would still not face the outsized risks many news stories suggest. Between 1970 and 2012, only 0.012% of municipal bonds have defaulted, and only five have involved general obligation debt, according to Moody's data. Mr. Alwine does not expect a significant increase.
"The entire market should not be painted with that brush," Mr. Alwine said. "Municipal bankruptcies are expected to be rare, isolated events that are typically predictable. The investment merits of munis still hold: It's a high-quality* market with a low default rate; they have taxing power and are essential."
*A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.
- All investing is subject to risk, including the possible loss of the money you invest.
- Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
- Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
- Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.