A severe, widespread drop in personal income tax collections spells serious fiscal trouble for many communities, according to a new report from the Rockefeller Institute of Government.
Less taxes increase the risk that states will need to make mid-year budget cuts, raising the possibility that local governments might not meet their debt obligations — including payments their municipal bonds.
State personal income tax collections fell by 26 percent, or $28.8 billion, January through April 2009 compared to a year earlier. Thirty-four of 37 reporting states saw declines, the institute reports.
Meanwhile, estimated payments and income tax returns dropped by more than 30 percent in the same period, while withholding dropped by 6.9 percent.
It’s likely that states will be forced to consider further spending and revenue actions in 2010 and to confront large budget gaps when federal stimulus assistance ends in 2011, suggest the report’s authors.
How much added risk does this mean for municipal bond investors?
It depends on what kind of bonds you hold, and how long you hold them, say experts. If not defaults, they warn, the market for bond sales will be weaker for some time.
It’s important to protect yourself now: Several types of muni bonds that are responsible for most defaults, they say, and these types are easy to avoid.
From a buy-and-hold perspective, muni bonds still look pretty darn safe.
"There’s no evidence yet that we’re going to see widespread defaults,” says Matt Fabian, managing director at Municipal Market Advisors, an independent research and consulting firm.
"Issuers have become vastly more sophisticated than they were in the Great Depression, which is the last time there was a wave of issuer defaults.”
But if you need to sell them during the next five years, don’t expect reliable value because the market is in flux.
"The demand picture has improved, but I don’t think you can count on strong, consistent demand for your bonds now because of inflation pressures and risks of additional downgrades to the banks many munis rely upon for liquidity,” Fabian says.
Nor should investors expect to realize the values shown on their bond statements right now.
“Those figures are more art than science at this point because the market has become so difficult and illiquid,” Fabian notes.
Robert W. Doty, President of American Governmental Financial Services Company, isn’t worried in general about municipal bond defaults, either.
"There could be isolated instances of problems, but even in California, where the state has mismanaged money for years, I’m really not very concerned about payments not being made,” Doty says.
“If there’s a general obligation bond that goes into default for anything other than a very small community without much diversity, I’ll be surprised.”
Fabian acknowledges more local bankruptcies are probable in California, but points out that since 1983 the total of municipal bankruptcies is only about 200 — and almost none were local governments that were big enough to have muni bonds outstanding.
The only current exception to this is Jefferson County, Alabama, which is trying to walk away from its bond obligations and scale down the debt on those it can’t shed.
Bonds to Avoid
However, both Fabian and Doty seriously caution that investors avoid risky sectors when buying municipal bonds, especially the following types of municipal bonds.
These types have accounted for 90 percent of muni market defaults over the past 30 years:
Corporate-backed muni bonds Apartment project bonds backed by the net income of a single building Nursing homes Land speculation bonds — also called “dirt bonds” — backed by the expectation of an increase in future property values such as a development Tax speculation bonds backed by a tax base that hasn’t yet developed Also, exclude hospitals, golf courses, startup utilities, and parking structures, Fabian and Doty adviseFocus instead on buying on general obligation bonds such as water-and-sewer-backed utilities and electric distribution systems, which have shown very, very few defaults in the past.
"An unlimited tax general obligation bond is very, very secure,” Doty says.
"If there are foreclosures and defaults, the tax rate goes up and those property owners who are paying just pay more, which presumably gets recovered through the foreclosure process over time.”
Choosing the best muni bonds to buy can be a little tricky, primarily because the ratings make municipalities look worse than they are, Doty notes.
He expects bond volume will be affected. Also, state and local governments will be reluctant to issue new tax-backed debt, and voters will be less willing to authorize such debt.
For the first time ever, Fabian is pointing clients toward bond mutual funds instead of direct purchase.
"It’s difficult for individuals to mimic the kind of flexibility a good bond fund manager has,” he observes.
"I am a strong believer in buying bonds directly, but right now, most investors are better off with a mutual fund.”
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