Municipal Fixed Income | August 2012
Look beyond the headlines: Municipal bankruptcies may present opportunities for those who do their credit researchBy Lyle J. Fitterer, CFA, CPAManaging Director, Head of Tax-Exempt Fixed Income, Municipal Bond Fund
Three California cities—Stockton, Mammoth Lakes, and San Bernardino—have declared bankruptcy since June 28. More cities are talking about the possibility of entering Chapter 9 bankruptcy protection. What are the implications for municipal bond investors? We believe that understanding a local government's various debt structures is important not only for avoiding pitfalls, but also for assessing relative value and finding investment opportunities across the country and in California.
Conditions in California are uniqueWe do not believe that we are likely to see a burst of bankruptcies from local governments in other states because the circumstances facing California cities are unique. In California, the state law known as Proposition 13 limits local governments' ability to raise revenues from property taxes. Additionally, local redevelopment agencies were used to spark development in many communities. Over time, some municipalities relied on excess receipts from these redevelopment projects for their general funds. Unfortunately for the cities, the state of California recently dissolved redevelopment agencies, partly to improve its own finances. Lost redevelopment revenues and limitations on revenue generation from Proposition 13 contributed to the pressures on some of the most troubled cities, including Stockton and San Bernardino.
State cooperation during times of fiscal stress helps local governmentsStates with strong oversight of their fiscally impaired local governments tend to encourage the municipality to fully honor its debt and retain access to the capital markets. California's oversight legislation, known as AB 506, calls for a 60-day mediation process in advance of a new bankruptcy filing. While many describe California's approach as hands-off, our concern with this legislation is that it is costly and doesn't do enough to protect bondholders. In our view, it offers weak enforcement of progressive negotiations and targets some creditors— primarily bond insurers and institutional bondholders— without appropriately involving larger creditors, namely the labor unions and pension system that are often the largest expenditures. Finally, it adds legal costs on top of already strained finances.
Some states that have good precedents for working with local governments include Michigan, Rhode Island, and Pennsylvania. Pennsylvania's Act 47 program places communities into an oversight program to consult on financial procedures until the community has shown sufficient strength to exit. We believe that such oversight has provided additional security for investors in Pittsburgh and the 19 other governments operating under its guidance. Alabama is at the other end of the spectrum. Here the state had several opportunities to help beleaguered Jefferson County, but it did not. The state legislature also failed to allow for the reinstatement of a wage tax that generates $60 million in revenue. Communities may lose market access if their state is unwilling to get involved or provide the tools for the community leaders to improve their finances. Investors need to understand the state oversight mechanisms, legal precedents, and tools available to local municipal managers to make an accurate assessment of fair value in times of distress.
Opportunities within municipal debt structures— examples from San BernardinoWe expect different types of San Bernardino bonds to have different outcomes. Of San Bernardino's $211 million debt outstanding, only $69 million (33%) is payable from the general fund, meaning the other $142 million (67%) is backed by revenue streams and is not subject to the bankruptcy proceedings. There is no direct general obligation debt outstanding, but there are lease, certificates of participation (COP), and pension obligation bonds (POBs) payable from the general fund.
Table 1 | Nearly one-third of the San Bernardino city debt is paid from the general fund, while more than two-thirds have dedicated revenue sources.There is another $2.8 billion debt outstanding with "San Bernardino" in its name, such as county and school district debt, which is not affected by the bankruptcy.
San Bernardino city general-fund COP and POB debt seems to be the least protected from the city's bankruptcy. Recent bid-side price indications for the uninsured pension obligation bonds were only $35 (the value of a bond is typically expressed in increments of $100; the example represents a 65% discount to the face value of the bond). By contrast, several AA-rated, insured lease bonds recently traded between $93 and $96. The other city debt, such as the water revenue and sewer COPs, initially traded lower but regained footing given the statutory lien provided to bondholders.
In our view, some bonds that were separate, distinct legal issuers but with “San Bernardino” in their name or that were located in the same geographical area were unfairly tainted by the bankruptcy. Investors without in-depth credit resources tend to avoid and even sell bonds that can be at all associated with a negative event; in this case, these included San Bernardino County, college district, and school district bonds. For those investors who can “look beyond the headlines” and do their own research, it was an opportunity to buy what we believe to be solid credits at an undervalued price.
Concluding observationsMunicipal issuers cover a broad spectrum, from a few in default to those that are benefiting from a renewed focus on improving their financial health or an improving economic environment. It, therefore, is essential to monitor each municipality based on the specific laws within its state and the various bond structures available. In our view, opportunities for value can be found in some of the various pricing inefficiencies that develop during such periods of heightened headline risk and market uncertainty. Our investment strategy has been, and will continue to be, to do our homework and invest in solid credits when they represent good value.
Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. The use of derivatives may reduce returns and/or increase volatility. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to active trading risk, high-yield securities risk, and municipal securities risk. Consult the fund's prospectus for additional information on these and other risks. A portion of the fund's income may be subject to federal, state, and/or local income taxes or the alternative minimum tax (AMT). Any capital gains distributions may be taxable..