Municipal Bonds: Risk v. Reward

Posted on January 10, 2011 by David Laidlaw 

Municipal bonds have decreased in value substantially over the last few months.  From September 30th to the end of the year, the broad muni bond market has declined over 6% as exemplified by iShares National Muni Bond Market ETF (symbol: MUB).  A 10-year municipal now yields about 3.45% which is slightly greater than the 10-Year US Treasury Note.  Municipal bond yields have increased roughly 0.5% over the past 6 months.  In a “normal” market, municipal bonds typically yield less than US Treasury bonds since interest from municipal bonds is typically exempt from Federal Income taxation (excluding the recently introduced Build America Bonds).  Even with lower yields, many higher income investors prefer to allocate a substantial portion of their fixed-income investments to municipals since their after-tax return is higher.  

Given the weak finances of many states and municipalities, the question arises as to whether or not the risk of default is sufficiently priced into these securities.

Illinois is currently the state with the most dire fiscal problems.  According to a recent article in Bloomberg on January 3rd, the state’s budget deficit is currently $13 billion which is fully one-half of the state’s current budget.  The balance sheet is in a similar state of disrepair: Illinois has $64 billion in assets, but a huge $126 billion in liabilities including such items as benefit obligations for the state’s 723,000 employees and retirees.  Illinois’ revenue has fallen sharply during the recession, but its spending and liabilities have increased throughout the downturn.  The state is resorting to such tactics as selling bonds based on future tobacco settlement payments.  These tactics are not sustainable since they only serve to accelerate funds to the state’s coffers by borrowing against future revenues.

There is also little that the state can do as far as raising additional revenues.  Governor Pat Quinn’s proposal to increase the income tax from 3% to 4% would only raise $3 billion in additional revenues.  Therefore, if Illinois only relied on its income tax, it would need to increase its income tax to more than 7% to close its current deficit.

Moody’s, the bond rating agency, rates Illinois bonds A1 with a negative outlook, meaning that future downgrades are likely.  Credit default swaps on this debt cost about 3.5% per year to insure against default.  A 10-year Illinois general obligation bond currently is priced to yield about 5%.

Given the state’s predicament, we do not believe any of these bonds represent good investments.  We would need to see yields in the high single digits before considering such risky paper.  While an extreme example, many other states face very comparable issues: their deficits and obligations are much larger than their ability to raise revenues.
A number of bond investors have taken the contrarian view and been touting the attractiveness of muni bonds at these prices.  The managers argue that defaults could increase, but that the likelihood of default is so far below 1% that the municipal bonds have good risk reward characteristics.

These managers also point to the low debt service costs relative to total revenues.  This logic only goes so far since, while the states and local governments do have the ability to refinance their debts and pay their obligations, this debt service reduces the general funds that are available for states to provide such vital services as education and infrastructure support.  We have no idea which interest group between bond holders, state employees and citizens that rely on services have the most bargaining power, but such a scenario entails significant risk either way.

The Federal Government is the wild card in the municipal finance game.  The US Government bailed out the banks and car companies two years ago during the financial crisis.  Would the Feds also bailout the states?  Many of the extended municipal securities seem to have this type of protection built into their prices even though it is an open question whether or not the states would receive financial backing from the Federal Government.