A Perspective on Municipal Bonds

Overview

With stubbornly high unemployment, shaky consumer confidence and tepid economic growth hampering income and sales tax revenues, concerns have been raised about the ability of various state and local governments to meet projected budget shortfalls. With that in view, we thought it timely to weigh-in on the state of the municipal bond market by providing our perspective and some facts. 


While municipal finances remain challenged, recent municipal bond market volatility is due to a spike in the supply of newly issued bonds, not a sudden deterioration in credit.

Due to fears that Congress may not extend the taxable Build America Bonds (BABS) program past year end, many municipalities are rushing to issue BABS, along with tax-exempt bonds. As a result, a slew of new bonds has hit the market in recent weeks. Also, if the BABS program is not extended, we could see tax-exempt supply increase by one-third next year. Coupled with the fact that taxes may not be rising as fast as expected, future demand for municipal bonds may soften, thus creating the unfavorable near-term supply imbalance. 


If anything, municipal credit quality has modestly improved this year.


Recent articles about deteriorating credit scenarios for states and local municipalities abound. This is not new information-these same concerns about municipal credit quality have been expressed for the last few years. While local governments face budget shortfalls, the majority of municipalities are beginning to address their individual problems, and we are observing subtle signs of an improving situation. In fact, many municipalities are actually seeing small revenue increases, making initial budget cuts, and negotiating with employees over wages and benefits. Furthermore, unlike the federal government, state and local governments are mandated by law to run on balanced budgets.



In general municipalities, have manageable debt loads and will go to great lengths to protect their credit ratings and their access to inexpensive public financing.

Municipal debt payments are generally a modest 5 to 10 percent of total general fund expenditures for the average municipality. In addition, issuers have historically spared no effort to ensure that bondholders are made whole, even at the expense of other payments or lower priority creditors. 


Municipal defaults are still extremely rare, which explains why they are so newsworthy.

In the unlikely event of a default, the ability of municipal bondholders to ultimately recover principal and interest payments has been high, with recovery close to 100 percent for general obligation and essential revenue bonds. Many municipalities, such as those in Oregon, are prohibited by statute from filing for Chapter 9; instead, services must be cut back to balance budgets 
.

General state and local government budget facts

• Many municipalities have tapped unreserved fund balances and rainy day funds 

• Throughout 2010, approximately 77 percent of states enacted budget cuts 

• States have decreased employment rolls by 39,000 since August of 2008
• Local municipalities have decreased employees by 368,000 since August of 2008 

• 56 percent of states enacted tax and fee increases 

• On average, state tax revenue rose 3.9 percent in the third quarter, creating a third straight quarterly gain 


Public pension plan facts

• Funding levels from the 1950s to the 1970s were the same or lower than today
• The average state pension was funded at 84 percent in 2008, higher than the average in 1970
• Even states with the weakest funding rates had enough assets at the end of 2009 to cover pension costs by 10 times or more
• State and local governments still need to address their pension liability issues; however, unfunded pension liabilities, by themselves, do not mean budgetary insolvency and default



Ferguson Wellman has not changed its strategy on municipal bonds based upon the recent market volatility.

Although the historical incidence of a municipality failing to meet its debt is extremely rare, the risk of default still exists. The political climate also has a direct bearing on how the municipality chooses to address its financial challenges. Nonetheless, the severity of problems facing municipalities varies greatly from state to state and from city to city.